Report No. 15288-CHA The Chinese Economy: Fighting Inflation, Deepening Reforms (In Tw.Vo Volkines) Volunie l: The Main Report April 4, 1996 Country Operations Division China and Mongolia Departmient East Asia and Pacific Regional Office u Document of the World Bank CURRENCY EQUIVALENTS (March 1996) Currency Unit: Yuan (Y) $1.00 = Y 8.31 Y1.00 = $0.1203 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System The Chinese Economy Fighting Inflation, Deepening Reforms Volume 1: The Main Report April 1996 World Bank Contents Overview v Chapter I Recent economic developments: stabilization with growth I Growth, inflation, incomes, and employment 1 External trade and the balance of payments 4 Monetary policy 7 Public finance 8 Conclusion 9 Part 11 Structural reforms for rapid, sustainable growth I I Chapter 2 Reforming state enterprises: the unfinished agenda 13 The problem 13 The government's response 15 Experimentation by local governments 16 The unfinished agenda 17 Chapter 3 Financial sector reforms: major issues and policy options 23 Recent progress in financial sector reforms 23 The credit plan 26 Interest rate policy 27 The central bank 30 State commercial banks 32 Policy banks 33 Nonbank financial institutions 34 The capital market 35 Chapter 4 Reforming public finances 37 Expenditure needs 37 Mobilizing revenues 40 Intergovernmental resource transfers 41 W Acknowledgments This report is based on the findings of a mission that visited Director, Comprehensive Department, Ministry of Finance; China in November 1995. Mission members were Vikram Pan Xiaojian, Deputy Director, World Bank Department, Nehru (mission leader and task manager), Vargha Azad, Ministry of Finance; Xu Jiatong, Director, State Admin- Bert Hofman, Aart Kraay, Liu Dusheng, Tamar Manuelyan istration of Taxation; Jian Qiangui, Director, Enterprise Atinc, Zhou Xiaobing, and Eduardo Borensztein (IMF). Department, State Economic and Trade Commnission; Wu Harry Broadman, Hongjoo Hahm, Deena Khatkhate, Xiaoling, Deputy Director General, State Administration of Surinder Malik, and Richard Newfarmer also contributed to Exchange Control; Qiu Xiaohua, Chief Economist, State the report. The peer reviewers were Pradeep Mitra, William Statistical Bureau; Li Weicheng, Professor, International Easterly, Nicholas Lardy, and Linda Koenig. Trade Research Institute, Ministry of Foreign Trade and Eco- The World Bank team benefited from fruitful discussions nomic Cooperation; and Li Keping, Division Chief, Macro with many government officials, who were generous with Systems Control Department, System reform Commission. their time and knowledge. The mission is also grateful to the Mei Hong, World Bank Department, Ministry of Finance, members of the counterpart team, which included Gao Jian, coordinated arrangements on the government side. iv Overview For the first time since economic reforms were initiated in The pressure on monetary policy was eased by a reduction 1978, the government cooled an overheated economy in the aggregate public sector deficit and a shift toward non- without stalling growth. But keeping growth high and infla- inflationary sources of finance. The key reason was stricter tion low wfi be difficult and wfi require maintaining the controls on state enterprise investment. The government bud- momentum of economic reforms to increase the efficiency get deficit contracted only marginally as a share of GDP? of investment, while moving to indirect techniques of Underlying -this, however, was a continued relative decline in macroeconomic management. government revenues, which slipped to 11.3 percent of GDP Of significance was the increased reliance on noninflationary Stabilization with growth sources of deficit finance, especially bor-rowing from the pub- lic (using treasury bonds). This underlined the govemrnment's China's remarkable success in lowering inflation to below resolve to bring inflation under control. 15 percent in 1995 while keeping GDP growth above 10 Looking ahead, the government is in a good position to percent was accomplished through a judicious combination keep inflation below the target rate of 10 percent a year in of administrative measures and macroeconomic policies. 1996 while maintaining GDP growth in the 8-9 percent Good weather helped too; grain output reached record range. But this will still require skilled macroeconomic levels (465 million tons), pushing agricultural growth to 4.5 management. Inflation could accelerate if credit expands percent, raising real incomes in rural areas, and relieving prematurely, especially since prices were admiinistratively upward pressure on food prices, repressed to some extent in 1995, and because of renewed Stabilization of the domestic economy was accompa- strength in the growth of investment and industrial pro- nied by further improvement in the external accounts. The duction in the last quarter of 1995. These considerations trade surplus reached US$17 billion in 1995, and the cur- warrant a cautious stance on monetary policy in early 1996, rent account surplus expanded to 2 percent of GDP (after although room for relaxation may appear as the year pro- being in deficit just two years before). Inflows of foreign gresses, especially if inflationary pressure from the external direct investment climbed to US$38 billion, and foreign account recedes with a slowdown in export growth. exchange reserves exceeded US$73 billion by year's end (equivalent to seven months of imports). High reserves and Structural reforms for sustained growth continued strength in exports eased the need to borrow with stability abroad. China's debt indicators improved further, reinforc- ing its strong credit standing in international markets. In the medium term, sustafining growth and maintaining sta- Broad money maintained its rapid expansion in 1995 on bility will require continued progress in structural reforms. the strength of rising foreign exchange reserves and higher- Efficiency gains from economic reforms have played an than-expected growth in domestic credit, as state commer- important part in China's impressive growth performance cial banks found new ways to circumvent the credit plan. since 1978. Harvesting these gains will be as important in the Despite this, inflation continued to fall. Contributory fac- future, if not more so. tors to the slowdown in inflation were a trend decline in the To do this, the government will need to maintain the velocity of broad money, weaker growth in narrow money, momentum of reforms in two strategic directions, The first and ernhanced price surveillance and higher subsidies at the would place greater reliance on market forces, with an retail level, which moderated the price increases of essential emphasis on state enterprises and the financial sector. As commodities. banks and enterprises become more responsive to market v signals, indirect macroeconomic management will become * Accelerate the transfer of pension, health, and education more effective. This, in turn, will ease the phaseout of obligationsfrom state-owned enterprises to government author- administrative controls, further enhancing productivity ities. It would be difficult to liquidate, sell, merge, or growth. The second would stress restoring the health of restructure enterprises if they were still required to meet government finances by raising government revenue as a these social expenditures. Pilot programs to transfer such share of GDP and shifting the focus of government expen- expenditures to municipal authorities need to be accelerat- diture policy toward such priority areas as health and edu- ed. At an appropriate point, these could be merged with cation, poverty reduction, infrastructure development, and the national pension and health program. environment protection. * Further promote competition to encourage greater efficiency in state enterprises. Of importance would be the reduction of State enterprise reform interprovincial and international trade and investment bar- riers. Lower foreign trade and investment barriers would There is virtually complete agreement within China that have the added advantage of strengthening China's case state enterprise reform is of the highest priority. State for joining the World Trade Organization (WTO). enterprises absorb a disproportionately large share of the In implementing these policies, consideration will need country's resources; they have also become a drag on to be given to the specific needs and circumstances of dif- growth and employment creation. ferent groups of state enterprises. The government's enterprise reform program operates at * Use competition and governance policies, not subsidies, to two levels: improving economic performance through foster the efficient development of the Central Government's stricter market discipline and developing better governance priority 1,000 large state enterprises. These state enterprises within firms to improve productivity. State-owned enterpris- and enterprise groups are expected to eventually form the es are being disciplined by the market through tough com- core of China's modern enterprise system. An appropriate petition created by trade liberalization and the proliferation way to improve their efficiency would be to provide these of nonstate enterprises. At the same time, financial support enterprises greater management autonomy and better gov- for state enterprises is being cut back. The combination of ernance structures, expose them gradually to domestic and these two pressures is encouraging enterprise restructuring, international competition, diversify their sources of especially at provincial and municipal levels. finance, and apply better regulations. In cases where the The stated policy of the Government is to strengthen government feels compelled to provide subsidies, these state enterprises and maintain their position as the mainstay should be limited, time-bound, and channeled through the of the economy To focus its efforts, the Central Government budget rather than the financial system. recently selected 1,000 large state enterprises as priority for * Improve the efficiency of 14,000 large and medium-size reform and development. For the other state enterprises, a industrial enterprises by diversifying ownership, reconfiguring variety of approaches to reform are underway in the form of operations, restructuring debt, encouraging mergers and consol- experiments at the provincial and municipal level. idations, and, where necessary, by liquidating. Marginal loss- Looking ahead, the task of improving the efficiency and making firms that are inherently viable financially could be competitiveness of China's state enterprises is expected to restructured by shedding labor, investing in new equip- be complex and difficult. This report recommends three ment, and reengineering finances. Debt restructuring underlying sets of policies that should provide the frame- should occur only when a corporate strategy is agreed work for state enterprise reforms in the future: between the bank, the (local) government, and enterprise * For all state enterprises, implement programs to improve management, and on the strict understanding of no future internal governance, diversify ownership, and lower budgetary bailouts. Heavy losers with little future would need to be and financial subsidies. A first priority would be to implement closed down, while highly profitable enterprises could be the new accounting system, set clear commercial objectives, corporatized. streamline asset management bureaus, clarify representa- * Systematically develop and implement a program to transfer tion of the government on boards of directors, and transfer the remaining 90,000 small industrial state enterprises to the autonomous management rights to enterprises. nonstate sector through sales, leases, or mergers. The govern- vi THE CHINESE ECONONMY: FIGlTING INFLATION, DEEPENING REFORMS ment's proposed policy for such enterprises is to loosen activity will take their place (World Bank 1994). Important controls on leasing, mergers, sales, restructurings, and among these is control of monetary aggregates through bankruptcies. But the government should go further and open market operations. These considerations inform the systematically facilitate the transfer of these enterprises to following seven recommendations on financial sector the nonstate sector. A first phase could include the transfer reform in China: of 10,000-20,000 state enterprises in the eighteen reform * Reduce the scope and detail of the credit plan. State com- cities over two years. mercial banks already enjoy a little freedom in allocating fixed asset investment loans. By the end of 1997, it would Financial sector reforms be reasonable to expect that they would design their entire lending program on their own. The government could Problems in the financial sector mirror those of state enter- maintain some influence on credit allocation by placing prises. The parlous condition of public finances has placed ceilings (for example, not more than 10 percent of total a growing burden on banks to fund state-directed invest- loans to real estate) or floors (for example, not less than 20 ments and extend working capital loans to loss-making percent of all loans to agriculture). enterprises. The government's credit and investment plans * Reformi interest rates in phases, reducing the most egregious steer the bulk of bank resources toward state enterprises at distortions quickly and subsequently extending greater freedom government-determined interest rates. The result is a bank- to financial markets to set interest rates. This is a complex and ing system with insufficient banking skills and a high pro- sensitive policy issue and needs to be approached prudent- portion of nonperforming assets; a central bank with limit- ly, but without delay. In the next two years, the government ed experience in monetary management, few policy instru- could immediately reduce the number of officially deter- ments, and inadequate regulatory and supervisory capacity; mined interest rates from over 200 to 30 or fewer; let mar- and a volatile capital market. ket forces increasingly drive treasury bond pricing, initially Previous attempts at liberalizing the financial sector by making purchases voluntary and eventually by introduc- accentuated macroeconomic instability because central ing treasury bill auctions; set interest rates quarterly, or bank controls were weak. They also shifted the pattern of more frequently if market conditions warrant; and expand investment in directions deemed undesirable by the gov- bill rediscounting by the central bank and open market ernment. Learning from these experiences, the govern- operations. The government could consider flexibility in ment launched a gradual process of change across virtual- lending (but not deposit) rates once it is satisfied with ly the entire financial sector in November 1993. Important progress in commercializing state banks. The central bank features of these reforms include measures to strengthen could allow all commercial banks to set interest rates freely the central bank, the creation of three policy banks to on a small portion of their portfolio, which could expand channel government-directed lending, and the transforma- with time, or it could gradually widen the bands within tion of the four specialized banks into genuine commercial which interest rates could fluctuate. Once the net worth of banks. banks was significantly positive, intermediation margins Building a stable, efficient, and safe financial system in were acceptable and sustainable, and adequate loan loss China will be a lengthy and complex process. In addition to provisions were available to protect banks from the possi- policy changes, it will require institutional and human bility of nonrepayment of loans, the central bank could resources development in areas as diverse as banking and introduce greater flexibility in deposit rates. accounting, government and public finance, and the judi- * Facilitate the transformation of state commercial banks into cial system. In addition, financial sector reforms will need genuine commercial banks. The government could consider to be synchronized carefully with reforms in other sectors increasing competition in the banking system, although of the economy, especially with state enterprise reforms. state commercial banks should be allowed to work out A primary objective of financial sector reform in China their inherited problems before they are exposed to full- is to phase out direct controls by government while relying blown competition. The banks, for their part, need to increasingly on commercial criteria. As these direct controls develop management information systems and introduce are withdrawn, indirect methods of influencing economic techniques for risk and asset-liability management, credit OVERVIEW vii and risk evaluation, liquidity management, and risk-based Reform of public finance provisioning. * Shape the operations of policy banks to make them consis- Reforming public finances is as much part of establishing tent with financial sector and public finance objectives. Policy a market economy as reforming state enterprise and the banks should not be expected to bear the risks of lending financial sector. The government budget needs to accom- to projects not of their own choosing; nonrepayment of any modate costs associated with market reforms, including such loans should be covered by the budget. In addition, budgetary contributions for a reformed social insurance the yield on policy bank bonds placed with state commer- system. At the same time, the budget needs to support cial banks should be aligned with bank lending rates to pro- development of critically needed social and physical infra- vide an accurate reflection of the actual cost of borrowing. structure to sustain a rapidly growing economy. The Ultimately, the placement of policy bank bonds should be steady decline of government expenditures over the last entirely voluntary, with the subsidy element in lending rates decade and a half has meant that some high priority gov- covered by the government budget. ernment activities have been underfunded. These include * Improve the central bank's management of monetary aggre- the provision of health and education services, poverty gates. In the short term, the central bank could use such alleviation, infrastructure development, and environmen- existing instruments as reserve ratios, asset-liability ratios, tal protection. Our rough estimates indicate that funding and the rediscount facility to manage monetary aggregates these additional expenditure needs could amount to 4.6 more actively. Open market operations can then be increas- percent of GDP. That would bring budgetary and extra- ingly relied on to make short-term adjustments in liquidity budgetary expenditure requirements to about 22.5 per- For open market operations to succeed, however, the cen- cent of GDP. tral bank will need to permit greater flexibility in interest This level of expenditures will necessitate additional rev- rates in the money market and at the shorter end of the enues of about 6 percent of GDP, if the government's goal maturity spectrum. At the same time, central bank supervi- of a balanced budget is to be achieved. Raising that much sors will need to ensure that banks follow its prudential revenue will require a combination of continued economic guidelines in spirit and in practice. growth, a broader tax base, and improved compliance - Strengthen regulatory oversight of nonbank financial institu- through better tax administration. The options available to tions. Laws on the operation and supervision of nonbank government are to: financial institutions need to be enacted to ensure that these * Improve the coverage and compliance of the value added tax. institutions conform to international norms of investor pro- By stepping up enforcement, the average compliance rate tection and information disclosure. To protect banks from could be raised from the present 70 percent to 85 percent by risks emanating from nonbank financial institutions, the the end of the decade. severance of ownership links between the two should be * Increase the application of the individual income tax. completed. Keeping the exemption constant in nominal terms (as was * Increase the efficiency, stability, and transparency of capital done in 1995) would bring an increasing number of people markets and lower systemic risk. The steady shrinking of the into the tax net, gradually increasing revenues. credit plan will permit gradual elimination of quotas for - Merge the foreign and domestic enterprise income tax rate. share and bond issues, while gradual interest rate liberal- This would not yield substantial revenues in the short term, ization will facilitate the issuance of government bonds but revenues would rise rapidly when the profits of foreign and deepen the bond market. To help develop the prima- enterprises rise. ry market, standards for credit rating agencies should be * Increase taxes on pollutants. Not only will such taxes set, competition among underwriters could be encour- encourage environmentally responsible behavior, they are aged, and the regulatory regime and oversight could be also easy to collect, and the sheer quantities of pollutants strengthened. In the secondary market, the bond markets makes such taxes attractive. of Shanghai, Shenzhen, and Wuhan could be linked, and * Introduce social security taxes. Some form of social secu- daily price limits could be introduced to curb unusual rity tax will become necessary to finance the basic pension volatility. pillar for (urban) workers. viii THE CHINESE ECONOMY: FIGHTING INFLATION, DEEPENING REFORMS * Improve tax administration. A well-functioning tax direct controls over the economy need to be replaced by administration could significantly raise revenues from the indirect ones. An important example is the conduct of xiing tax structure. monetary policy and the use of open market operations. Another is the reform of public finances. Government Conclusion attention needs to focus on allocating additional resources to such high priority areas as basic health and education, Maintaining rapid growth with stability will require contin- poverty reduction, infrastructure development, and envi- ued market reforms and a reorientation of government ronmental protection. Mobilizing revenues to meet these involvement in the economy. Benefits from further reforms additional expenditure needs will be central to China's would probably be greatest in state enterprises and the ability to sustain rapid growth with stability. financial sector. The government has made some progress in both areas; it is now critical to complete these reforms Reference with due attention to phasing and sequencing. 'Xrld Bank. 1994. "Macroeconomic Stability in a Decentralized As important as market reform is the need for shaping a Economy," Report No. 13399-CHA, China and Mongolia new role for government in a changing economy. For one, Department, Wbrld Bank, Washington, D.C. OVEVIEW ix Summary of policy recommendations Objective Short term State enterprise reforms Improve govemance, diversify ownership, and lower subsidies Complete implementation of intemational accounting system. Increase autonomy to managers. Separate commercial activities from ministries and bureaus. Lower subsidies through budget and banking system. * Among the Govemment's priority 1,000 enterprises Incorporate 500 large state enterprises under Company Law. For utilities, establish clear regulations for tariff setting. * Arnong 14.000 medium and large industrial state enterprises Separate out marginal state enterprises and distinguish inherently viable from effecively bankrupt ones. Begin liquidating enterprises that have little chance of becoming viable. Corporatize the most viable enterprises. * Among 90,000 small industrial enterprises Transfer 10-20,000 small enterprises to the nonstate sector through mergers, leases, or sales. Transfer social services to govemment Transfer pension, health, and educabon obligations from enterprises to Govemment in at least the I 8 pilot cities, with compensatory fiscal transfers, if required. Introduce experimentabon with unemployment insurance system. Improve competition policies for all state-owned enterprises. Reduce scope of administered prices as competition expands. Phase out restrictions on inter-provincial trade and investment. Initiate free entry and exit. Remove tax biases favoring foreign firms and special economic zones. Contnue with rationalizaton of trade and investmnent regime as consistent with WTO accession agreements. Financial sector reforms Reduce govemment's role in determining the allocation and cost of capital. Reduce scope and detail of credit plan for commercial banks. Simplify interest rate structure and adjust interest rates more frequently, increase interest rate spreads to reasonable levels, and introduce wider bands in the interbank market. Improve central bank operations. Actively use indirect instruments of monetary policy. Improve institutional framework for the central bank. Transform state commercial banks into genuine commercial banks. Introduce sound management and accounting systems. Implement regulatory framework for commercial banks. Shape operations of policy banks consistent with financial sector and public Integrate policy banks fully into monetary and industrial policy framework. finance objectives. Provide adequate budgetary support to sustain voluntary placement of policy bank bonds and subsidized lending rates. x THE CHINESE ECONOMY: FIGHTING INFLATION, DEEPENING REFORMS Medium term Long term Complete transfer of all fourteen autonomous rights to managers within the framework of the Company Law. Extend incorporatbon to remaining priority state enterprises. Contnue program. Introduce debt restructuring if financial situaion and cor- Restructure remaining marginal, but viable, state enterprises. porate strategy are acceptable to banks. Continue liquidatbon of nonviable state enterprises. Complete liquidation of nonviable state enterprises. Incorporate enterprises made viable after debt restructuring. Incorporate all medium and large state enterprises. Extend program to 50,000 small state enterprises. Transfer all remaining small state enterprises to nonstate sector. Unify municipal programs into natbonal program for pension and healfth, and implement in remaining cities. Establish unemployment insurance program. Eliminate restrictions on inter-provincial trade and investment. Expand free entry and exit. Eliminate all restrictions to free entry and exit. Continue program. Complete program. Eliminate credit plan for commercial banks so that credit plan covers policy Eliminate credit plan for policy banks. banks only. Liberalize interest rates completely. Allow commercial banks greater autonomy in setting lending (but not deposit) rates. Expand use of indirect instruments. Review the Central Bank Law. Improve provisioning policies and practices. Achieve intematbonal standards of capital adequacy. Review the Commercial Banking Law. Increase the autonomy of the State Development Bank. Transfer the "soft" lending window to the budget. Introduce new funding and lending instruments. OVERVIEW Xt Summary of policy recommendations, continued Objective Short term Financial sector reforms, continued Improve regulatory framework for nonbank financial institubons. Further develop legal and regulatory framework of nonbank financial institutions. Complete separation of banks and nonbank financial institutions. Improve functioning of capital markets. Improve legal, regulatory, and supervisory framework. Improve scheduling, informaton, and pricing pracbces in primary markets. Improve framework for integrabng regional secondary markets. Public finance reforms Increase tax revenues. Strengthen tax administration. Enforce personal income tax law. Reduce income tax exemptons and preferences for foreign enterprises. Experiment with payroll taxes to finance social security payments. Experiment with taxabon of pollutants. Shift expenditure allocation. Initiate increases in budgetary allocabon for health, education, infrastructure, poverty alleviabon, and environmental protection, in line with revenue availability. Improve regional distribution of govemment revenues and expenditures. Develop intergovemmental grants scheme. Research earmarking of intergovemmental grants for specific purposes. Research fiscal transfers at subprovincial levels. Xii THE CHINESE ECONOMY: FIGHTING INFLATION, DEEPENING REFORMS Medium term Long term Restrict govemment ownership of nonbank finandal i _dbion. Enforce better information disclosure. Permt multiple listing. Initiate dual listing. Increase coverage of the value added tax. Improve personal income tax law. Merge foreign and domestic enterprse income tax rates. Introduce payroll taxes nationwide to finance social security payments. Increase taxation of pollutants. Unify budgetary and extrabudgetary funds management. Implement intergovemmental grants scheme. Consider allocating central grants directly to prefecturo o(fthe couties. Experiment with earmarked grants. Experiment with subprovincial grants. OVERVIEW ~~- Chapter 1 Recent economic developments: stabilization with growth Government policies helped lower inflation in 1995 and enterprises (chapter 2), the financial sector (chapter 3), and edge GDP growth down to a more sustainable level. The public finances (chapter 4). key measures included administrative restrictions on investment, careful management of central bank credit to Growth, inflation, incomes, and banks, increases in administered interest rates on commer- employment cial bank loans, and price controls and subsidies for some essential commodities. Improved conditions in agriculture China's stabilization policies in 1994 and 1995 proved suc- also helped, relieving upward pressure on food prices and cessful in lowering inflation and nudging GDP growth bolstering growth of output and incomes in rural areas. down to more sustainable levels. Inflation reached a peak The government's stabilization policies came at the cost of 25.2 percent in October 1994 (on a twelve-month basis, of rising interenterprise arrears, difficulties in stock and using the retail price index), driven by increases in adminis- real estate markets, and higher urban unemployment rates, tered prices for food, petroleum, fertilizer, coal, and steel, especially in areas with - high concentration of state enter- and accommodated by excessive monetary expansion, gen- prises. Nevertheless, aggregate demand was managed more erated in part from sharp increases in foreign exchange skillfully than in previous episodes of overheating and was reserves. Since then, however, inflation has declined steadi- accomplished against a backdrop of structural reforms and ly, reaching 8.3 percent in December 1995. The main factor major new economic policy initiatives. has been rapidly decelerating growth in food prices, As long as restraint in fiscal and monetary policies con- although the rise in nonfood prices has ebbed only gradual- tinues, the government is in a good position to achieve its ly since July 1993. Contributing to this decline in inflation 1996 inflation target of 10 percent and growth target of were administrative controls on investment by state-owned 8-9 percent. This would put the economy on a sound foot- units, a lower public sector deficit, sharply lower growth in ing at the outset of the Ninth Five-Year Plan. central bank credit, improved conditions in agricultural In the medium term, keeping growth high and inflation production and distribution, and a postponement of further low will require maintaining the momentum of economic upward adjustments in administered prices (figure 1.1). reforms and increasing the efficiency of investment, while Growth in GDP subsided from an unsustainable 13.5 moving to indirect techniques of macroeconomic manage- percent in 1993 to 11.8 percent in 1994, before descending ment. Nowhere is the potential for efficiency gains greater further to 10.2 percent in 1995.1 This slowdown was the than in state enterprises, the financial sector, and fiscal pol- outcome of three forces: a significant reduction in invest- icy. The government has already embarked on ambitious ment growth, an easing in export growth, and a rebound in reforms in all three areas (see chapters 2-4). Completing consumption growth. these reforms will be crucial in laying a solid foundation for Investment growth (in real terms) cooled from its fever- sustainable growth with stability over the medium to long ish pace of 24.8 percent in 1993 to 12.7 percent in 1994, term. and then to an estimated 10.5 percent in 1995. Grc vth in This report updates information contained in the World u-xed investment (which excludes inventory accumulation) Bank's previous Country Economic Memorandum on was slower still at an estimated 7.3 percent in 1995, down China (World Bank 1994a). The report begins with a brief from 21.4 percent in 1994 and 23.3 percent in 1993. The review of recent macroeconomic developments (chapter consequent slowdown in the growth of aggregate domestic 1). It then examines medium-term issues linking structural demand was compounded by an easing in export growth, reforms to sustainable growth, with special focus on state which had climbed from 8.8 percent in 1993 (in nominal I FIGURE 1.1 Inflation fell in late 1994 and through 1995 ... ... and GDP growth edged downward... Inflation: January 1"0-December 1995 Annual GDP growth (Percentage change of the index over twelve months) (Percent, 1990 prices) 45 Food pnce index," 8 16 40 35 , '1 30 25 'f 20 8 I15 6/\'\|1E__1 15 4 5 K2 0 W ~~~~~~~~~~~~~~~~~~Nonfood price index 2 0~~~~~~~~~~~~~~~~~~~~~~~~~ -5 0 Jan July Jan July Jan juy Jan July Jan July Jan July 1990 1991 1992 1993 1994 1995 1990 1991 1992 1993 1 994 1995 est. ...as the authorities restricted investments by ... tightened central bank credit... state-owned units... Growth of investment in state-owned units Domestic assets of the People's Bank of China (Percentage change over twelve months) (FPrcentage change over twelve months) 90 40 80 35 70 30 60 25 50 20 40 1 5 30 I 0 20 0 0 -10 -5 Jan July Jan July Jan July Jan July Jan July Dec June Dec June Dec June Dec June Dec June Dec June Dec 1991 1992 1993 1994 1995 1989 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 1995 ... lowered the public sector deficit ... ... and were helped by improved conditions in agriculture Aggregate public sector deficit Agricultural production and food price trends (Percent of GDP) (Percent) (Millions of tons) 1 6 4546 1 4 40 Grain prodiuction5 5 5 i'~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~right scale) 35 1 2 30 450 25 8 ~~~~~~~~~~~~~~~~~~~20 10 ~~~~~~~~~~~~~~~440 4 S 0~~~~~~~~~~~~~~~~~~~~~ 1987 1988 1989 1990 1991 1992 1993 1994 1995 Jan July Jan July Jan July Jan July Jan July Jan July 1990 1991 1992 1993 1994 1995 Source: China Statisutcal earbook, various issues: China Monthly Stotistics, various issues. Wodd Bank staff estimates. 2 TIlE CIIINESE ECONOMY: FIGHTING INFLATION, DEEPENING REFORMS U.S. dollars) to 35.5 percent in 1994, but then fell back to the share of se-vices (health, education, banking, and 23 percent in 1995. Countering these decelerating forces insurance). These increases were accommodated by on the demand side was the growth in consumption, which declines in the investment shares of industry and com- climbed from its low of 5.9 percent in real terms in 1994 to merce. Where the government was unable to curb invest- an estimated 6.7 percent in 1995. As a result, the accelera- ment growth was in real estate; here, the share increased tion in consumption spending completely offset the slow- marginally, although the intention was to lower it. down in investment demand (table 1.1). The rise in consumption growth can be attributed main- Investment demand groxvth in 1995 was kept in check ly to two developments. One was the 40 percent increase by tight administrative controls on new investments by in the wage bill in 1994 and accompanying increases in state-owned units, a sharp slowdown in net lending by the nonwage benefits, which raised the urban average annual People's Bank of China, and increases in interest rates. But income per capita by 4.9 percent in real terms. A second these measures were managed more skillfully than in previ- was the rise in rural incomes in 1995 (estimated at about ous stabilization episodes. According to the authorities, 5.3 percent in real terms) following the rapid increase in investment expenditures, while controlled more strictly, the relative price of food products and the procurement were not reduced drastically or cut across the board. An price of grain in 1994. attempt was made to weed out less viable investments and These developments indicate a small narrowing in rural- to consolidate resources in key high-priority projects. New urban income differentials in 1995 after more than a decade project starts were discouraged, and project approval limits of almost continuous widening (figure 1.2). According to for subnational governments were lowered. Lower the government, virtually all of China's 70 miHion poor live approval limits meant that, for the first time since 1990, in rural areas.2 The rise in rural incomes suggests further growth in investment by the central government exceeded reductions in the number of poor, although a lack of data that of lower-level governments. Contrary to any previous makes this judgment difficult to verify cycle since 1978, growth in investment by nonstate firms Net exports continued to contribute to growth in 1995. surpassed that of state-owned units during this investment Exports climbed an estimated 23 percent while imports downswing. increased only 14.2 percent. The trade surplus increased Tlhe government also attempted to alter the structure of more than twofold from US$7.3 billion in 1994 to US$17.3 investment during this period. The share of agricultire billion in 1995. The improvement in the trade balance con- increased markedly, in line with the government's stated tributed an estimated 17 percent of GDP growth in 1995, intention of boosting agricultural growth. Similarly, the compared with 20 percent in 1994 and negative 21 percent share of investment in physical infrastructure (energyv in 1993 (figure 1.3). transportation, and telecommunications) climbed, as did F GURE I 2 TABLF 1. I Rural-urban income differentials narrowed in 1995 GDP growth and its components Ratio of rural to urban incomes and the rural-urban terms of trade (percent a year. at 1990 prices) Income ratio Terms of trade 1984--93 1994 1995' 60 Ruralurba 200 ncm rai 190 GDP 10.5 1 1.8 10.2 55 (left .s) 1 80 Expenditure category Consumpton 10 1 5.9 6.7 170 Investment I I 6 12.7 1I0.5 160 Exports 12.4 28.6 15.6 I so Imports 13.3 8.9 10.7 140 By sector of origin 130 Agriculture 4 7 4.0 4.5 . Rural-uirban terms of Industry 13.3 17.4 13.6 40 trade (right axis) 120 Manufacturing 12 7 1 7.2 14.0 I Il Services 12.2 8.2 8 0 35 100 a. Estimated 978 1980 1982 1984 1986 1988 1990 1992 1994 Source China Statisticaf Yearbook govemnnent authorit es \'V;rld Bank staff est mates. Source Chsnc Stotist cct Yeorbook 1995 and Vvorld Bank siaff estimates. RECENT ECONOMIC DEVELOPMENTS: STABILIZATION WITI I GRO%flr I 3 On the supply side, the brunt of slower growth fell on be hampered, further aggravating problems in grain distri- the industrial sector, where growth in value added faded bution. Government procurement policies for grain from 17.4 percent in real terms in 1994 to 13.6 percent in remained virtually unchanged, as did those for cotton, 1995. The drop was largely the result of slower output where the government's monopsony remains unchallenged growth in nonstate firms. State enterprises actually on the strength of the three "do not open" policies (do not improved their performance in 1995, climbing from 6.5 open the business, do not open the market, and do not percent output growth in 1994 to 7.2 percent in 1995. open the price). Despite this, the share of state enterprises in industrial out- put continued to decline, eroded by a rapid increase in the External trade and the balance of share of private enterprises and individual-owned firms payments (see chapter 2). Slower growth in industry contributed to a small rise in China experienced a swing of 5 percentage points in its cur- the urban unemployment rate from 2.6 percent in 1994 to rent account balance in two years, from a deficit of 3 per- 2.9 percent in 1995. In some small cities, the unemploy- cent of GDP in 1993 to a surplus estimated at 2 percent of ment rate is above 10 percent. At the same time, the struc- GDP in 1995.3 For the second year in a row, export growth ture of nonagricultural employment is changing rapidly exceeded 20 percent (in nominal U.S. dollar terms). According to the Ministry of Labor, employment during the A confluence of events and factors contributed to this first half of 1995 declined by 1.3 million in state-owned dramatic performance: exchange rate unification in January units and by almost 1 million in collectively owned enter- 1994;4 a slowdown in domestic demand in the wake of prises. Employment in individually and privately owned decelerating investment growth; introduction of a new firms (including joint ventures and foreign-funded firms) value added tax (VAT) regime in 1994 that increased the increased by 4.8 million. effective tax credit for exports; the announcement in Despite floods in the south, generally favorable weath- March 1995 of a reduction of the VAT rebate rate mid- er helped improve overall performance in agriculture. year, which may have encouraged exporters to bring for- Value added in agriculture expanded by 4.5 percent in ward their export shipments; large increases in the produc- 1995, significantly higher than the 3.5 percent growth tive capacity of export-oriented foreign direct investment; achieved in 1994. Summer grain output was just below the and strong demand in export markets. But monthly data record harvest of 108 million tons in 1993, with yields up show that the bulk of the acceleration in export revenues in by 1.4 percent. The "governor responsibility system" intro- 1995 occurred in the first half of the year, when export duced in February 1995, which makes governors responsi- earnings were significantly above trend. Monthly export ble for balancing supply and demand for grain in their revenues declined steadily through 1995, having reached regions, raised fears that interregional trade in grain could their peak in January (figure 1.4).5 By December 1995, they were 6.8 percent below their level in December 1994, FIGURE 1.3 contributing to a trade deficit of US$1.2 billion for the Investment's shrinking share in growth month. In the absence of any unusual developments, Sources of growth, 1994 Sources of growth, export growth is likely to slow in 1996 in light of the con- 1995 (estimated) tinuing real appreciation of the renminbi and notwith- Consumption Neteport Cosption Investment 30.0% 19.7% 50.8% 31.8% standing the continued high levels of export-oriented for- eign direct investment that continue to flow into the coun- try (see below). Import growth in 1994 and 1995 was in line with past trends, although the composition of imports in 1995 shift- lnvestment Netexports ed from capital goods and toward food, reflecting domes- 50.3% 17.4% tic policy imperatives to lower pressure on food prices and Note: Annual increments as a share of incremental GDP (excluding stock accumulation); in constant 1990 prices. control investment expansion. China's complex govern- Source China Stotisticol Yearbook 1995; data provided by government authorities; World Bank staff estimates. ment-managed import regime explains some of the 4 TIE CIIINESE ECONONM: FIGIInNG INFLATION, DEEPENING REFORMS FIGURE 1.4 Above-trend export growth in the first half of 1995 ... ... and trend growth in imports... Export developments, 1989-95 Import developments, 1989-95 (Seasonally adjusted; billions of U.S. dollars) (Seasonally adjusted; billions of U.S. dollars) 16 12 14 12~~~~~~~~~~~~~~~~~~~~~~~1 12 Trerend 8ccount... 8 6 6 4 4 2 2 1994 1995 1994 1995 0 0 ---- - Jan July Jan July Jan July Jan July Jan July Jan July Jan July Jan July Jan July Jan July Jan July Jan July Jan july Jan JulY' 1989 1990 1991 1992 1993 1994 1995 1989 1990 1991 1992 1993 1994 1995 ... contributed to a sharp improvement in the ... and burgeoning foreign exchange reserves. current account... Extemal current account balance Gross foreign exchange reserves (Billions of U.S. dollars) (Percent) (Billions of U.S. dollars) (Months of imports) 20 4 80 7 Billions of U.S. Billions of U.S. IS dofiars ~ 70 doglars - \ Percent 3 Months of imports of 6 10f- afGDP i l 60 goods and services t0 5 2 so 5 4 s | | | 1993 1lL E 40 0 3 t990 1991 1992 994 1 995 30 -S \ / (estimated) 0 20 -10 I 10 -15 -2 0 0 1990 1991 1992 1993 1994 1995 (estmated) Note: See endnote 3 for a discussion on the revised esbmate of the current account surplus in 1995. Source: China Statistical tbarbook. various issues; ChmnaL Monthly Statistics, various issues; data provided by government authontes; World Bank staff estimates. restrained growth in imports. The regime is designed to ers, although evidence collected in 1993 suggests that some promote exports while protecting domestic producers from may not be binding (World Bank 1994b). Cutting in the competition. Almost half of all imports are processed into other direction, however, were restrictions on imports of exports and so go untaxed. Another significant fraction of automobile kits in 1994 and a ban on foreign investment in imports, destined for special economic zones, open coastal automobile production, which were designed to support cities, and foreign funded enterprises, enjoys preferential China's new automobile "pillar" industry under a new import duties. Only 15 percent of total imports are subject industrial policy launched in 1994 (see chapter 2). to tariff and nontariff barriers, including import rights, Such restrictions notwithstanding, recent announce- licensing, and quantitative restrictions. ments by China's leaders point to a steady liberalization in Nontariff barriers have been lowered steadily (table import policy, in part as a bid to enter the World Trade 1.2). Less than 10 percent of tariff lines were subject to Organization (WTO). At the Asia-Pacific Economic nontariff barriers in 1995, far fewer than three years ago. Cooperation (APEC) summit meeting in Osaka, Japan, in No data are available on the restrictiveness of these barri- November 1995, President Jiang Zemin announced that RECENT ECONOMIC DEVELOPMENTS: STABILIZATION WITTI GROWnT 5 on April 1, 1996, the government would cut tariffs on and Management Bureau investigated 5,570 FDI projects in 4,000 import items by not less than 30 percent, revoke or 1994 and found a 19 percent exaggeration of FDI from an alleviate import quotas and controls on 170 items (30 per- overvaluation of foreign investment entering the country in cent of all items subject to such controls), permit the estab- the form of imports of capital equipment (UNCTAD 1995). Iishment of joint-venture trading companies in certain A recent feature of China's economic relations with the cities on a trial basis, and allow the expansion of joint ven- outside world is the increase in outward foreign direct ture retail businesses. investment. Indeed, foreign direct investment flows from In the capital account of the balance of payments, for- China in the 1990s were the second largest among devel- eign direct investment (FDI) inflows reached US$37.7 bil- oping economies.7 By the end of 1994, over 900 Chinese lion by the end of the calendar year.6 About 80 percent of enterprises had established 4,600 foreign affiliates in 130 FDI projects are located in coastal provinces and 60 per- countries, with cumulative FDI outflows estimated at up to cent in industry. A recent study (Broadman and Sun 1995) US$16 billion (UNCTAD 1995, box I1.2). Of these, 50 shows that four factors-a province's market size, its level percent were in trading, 30 percent in natural resources of infrastructural development, the educational level of its (minerals, forestry, and ocean fisheries), and 15 percent in labor force, and its geographical location-explain 80 per- manufacturing. Hong Kong and Macau were the principal cent of the variation in the stock of FDI by province. To destinations of Chinese outward FDI, followed by North counter growing income disparities between regions and America (figure 1.5). provinces, the goverrunent has introduced new regulations The unexpected strength in the trade balance was large- to encourage FDI into interior provinces, especially in ly responsible for a sharp increase in China's foreign infrastructure and other high priority sectors. exchange reserves in 1995. This contrasted with 1994, Hong Kong and Macau investors continue to be the when developments in the capital account were the major largest source of foreign direct investment inflows into contributory factor. Foreign exchange reserves, only US$22 China, followed by the United States and Japan. But some billion in 1993 (excluding gold), had climbed to US$53 bil- of these data need to be interpreted with caution. Capital lion by the end of 1994 (or 5.2 months of imports) and outflows repatriated back to China to take advantage of reached US$73.6 billion by the end of 1995 (equivalent to generous tax breaks could be significant. If true, such about seven months of imports). "roundtripping" would be especially evident in FDI from High reserves and continued strength in exports eased Hong Kong and Macau. FDI inflows could also be exagger- China's need to borrow from international financial mar- ated for other reasons, such as overinvoicing imports. For kets, especially in 1995. Even so, net disbursements and net example, the Import and Export Comnmodities Inspection flows climbed higher from their previous peaks in 1993, with fresh commercial borrowing used largely to finance TABLE 1.2 infrastructure projects, maintain a strategic presence in key Widening doors to import competition: tariff and nontariff measures FIGURE 1.5 (percent) Destinations of China's outward foreign direct investment, 1979-1993 Unweighted Weighted average average Lati tariff rate tariff rate Non-tariff barriers Aria/ Amernca Africa _______________________________________________ ~ ~ ~ Pac'f' 2% 2% Early 1992 43.0 32.0 Applied to 1530 tanff lines Europe _ Hong Kong and End-1992 39.9 32.7 7. Macau End- 1993 36.4 30.7 Eliminated on 283 tarifl lines 8%Oceania 1% End- 1994 35.9 .. Eliminated on 206 tariff lines End- 1995 35.7 26.8 Eliminated on 367 tariff lines Early 1996 22-23 .. Eliminated on 170 tariff linesa Target, 1997 150b North America : a. President liang Zemin's speech at APEC summit, Osaka, Japan, dated November 2 1, 15% 1 995. b. Statement by Vice Premier Zhu PRorgji in November 1995. Source: Department of Customs Administration; government authorities. Source: Xing 1 994, as depicted in UNCTAD 1995 6 TfIE CIIINESE ECONONlMY FlGIITING INFLATION, DEEPENING REFORMS financial markets, and restructure the maturity of existing third quarter of 1995, contributing to barely undiminished debt. All indicators of sovereign creditworthiness remained momentum in the growth of broad money. The increase in largely steady in 1995 (table 1.3). While the debt-GDP ratio net foreign assets contributed 70 percent of reserve money declined from 19 percent in 1994 to an estimated 17 per- growth in 1994 and 60 percent in 1995. cent in 1995, the debt-service ratio remained stationary at But M2 growth was also propelled by net domestic around 9 percent as commercial debt borrowed in 1993 assets, which climbed 25.7 percent through 1994 and came due. These debt indicators point to China's strong 30.4 percent in 1995 (both twelve-month rates), this external position and sovereign credit standing in interna- despite the fact that the credit plan incorporated a mod- tional markets. At the same time, however, international est expansion in 1994 and 1995. The increasingly limited credit rating agencies downgraded the credit rating of some role of the credit plan as an instrument of monetary con- of China's largest non-sovereign borrowers. trol could be a consequence of the gradually declining Finally, China's balance of payments registered a dou- share of state commercial banks in the overall financial bhng in "errors and omissions," from about $10 billion in system and of the persistence of large incentives for state 1994 to over $20 billion in 1995, which was more than the commercial banks to devise new ways to circumvent the entire current account surplus.8 Reasons for such large credit plan.9 "errors and omissions" could include underestimation of Even though M2 growth showed little sign of slowing, profit remittances, overreporting of foreign direct invest- inflation continued to fall. There are three possible ment, overreporting of exports and underreporting of explanations. imports, and genuine unrecorded capital outflows resulting First, the velocity of broad money maintained its trend in increased holdings of foreign assets by Chinese residents. decline in 1995 (figure 1.6), reflecting heightened confi- It is important that the authorities redouble their efforts to dence in the banking system (following the disintermedia- improve the coverage and accuracy of balance of payments tion in 1993) and spurred, no doubt, by the introduction of statistics to provide a more reliable assessment of China's inflation-indexed interest rates for term deposits of house- external payments position. holds with a maturity of three years and longer. It is unlike- ly, however, that such a trend decline can be maintained for Monetary policy much longer, arguing for conservatism when setting M2 growth targets in the coming year. Moreover, the velocity The sharp rise in foreign exchange reserves in 1994 and decline in 1995 should be viewed with caution, as it may 1995 fueled strong expansion in reserve money through the partly reflect, in addition to increases in money demand, an TABLE 1.3 FIGURE 1.6 Debt and creditworthiness indicators, 1993-95 The declining trend in the velocity of broad money (billions of U.S. dollars) (M2) Log scale 1993 1994 1995' 0.50 Debt outstanding 84.2 98.4 112.8 Public and publicly guaranteed 70.1 82.4 92.2 Private nonguaranteed 0.6 0.6 0.6 0.40 Short-term debt 13.5 15.4 20.0 By creditor 0.30 Mukilateral 10.7 13.6 1 5.7 Bilateral 13.7 15.4 n.a. Commercial 59.8 69.4 n.a. 0.20 Creditworthiness indicators (percent) Debt-GDP ratio 14.1 19.3 17.0 010 Debt-service ratio 1 1.1 8.9 9.6 Interest-exports ratio 3.7 3.8 3.7 rn.a S not ava,lable. 0 a. Estimated 1987 1988 1989 1990 1991 1992 1993 1994 Source Wodd Debt Tables, government authornt,es; World Bank staff estimates. Source IMF RECENT ECONOMIC DE`VELOPMENTS: STABILIZATION WITH GRO%VM 7 incipient excess supply of money that will eventually feed A lower public sector deficit in 1994 was due to a sharp into higher prices. fall in the state enterprise deficit from 10.3 percent of GDP Second, the strong growth of M2 (29.9 percent growth in 1993 to 7.9 percent in 1994 (table 1.4). The shrinking through 1995 and 34.5 percent in 1994) contrasted with a deficit was a consequence of stricter control of state enter- more moderate expansion in MO (currency) and Ml. This prise investment, manifested by slower growth in credit, discrepancy may have derived in part from inflation- especially for working capital, and a sharp increase in enter- indexed deposit rates and the increased availability of prise deposits. Lower subsidies to state enterprises (as a financial services. But in a financial system in which most share of GDP), together with tighter constraints on credit, transactions are still conducted with cash, the slower meant that interenterprise arrears reached record highs. growth of currency in circulation probably contributed to The government budget deficit also saw a small decline more subdued aggregate demand. from 2.3 percent in 1993 to 1.7 percent in 1994. Third, enhanced price surveillance and local government Underlying this apparent improvement, however, was a subsidies for key commodities at the retail level helped continued decline in government revenues as a share of moderate inflation, at least temporarily. A relevant question, GDP, which slipped from 13.8 percent to 12.4 percent. therefore, is whether the government will be able to keep Revenue data for 1995 suggest little improvement, with inflation under control in 1996 while gradually removing revenues sliding further to 11.3 percent of GDP these temporary subsidies and controls. So far the govern- The new VAT has become the workhorse of China's ment has proved resolute in maintaining a reasonably reformed tax system, generating over 40 percent of rev- restrictive monetary policy. This stance is entirely appropri- enues in 1994 and the first three quarters of 1995. While ate, especially since growth in investment expenditures and VAT revenues grew satisfactorily in 1995 (at 22.4 percent industrial production showed renewed strength in the last over 1994), rebates on VAT to exporters were higher than quarter of 1995. As the year progresses, however, there may expected. These rebates, amounting to RMB 43 billion, be room for some relaxation of this position, particularly if may not seem unduly out of line with China's export per- inflationary pressures from the external account recede with formance, but they do appear high once account is taken of a slowdown in export growth. The challenge for the govern- processing trade, which is exempt from VAT."' Concerned ment will be to fine-tune the growth of the money supply about the level of rebates (not just because of suspicion of while relying more on open market operations and other widespread fraud, but also because the rebate rate yielded indirect methods of monetary management. higher refunds than the amount actually collected as VAT on inputs), the government reduced the rebate rate for Public finance manufactures to 14 percent in July 1995. A further reduc- tion of the rate to 9 percent was announced, effective The pressure on monetary policy in 1994 and 1995 was January 1, 1996. eased by a significant reduction in the aggregate public sec- In an effort to improve tax revenue collections, the gov- tor deficit and a shift toward noninflationary sources of ernment is reducing or eliminating a variety of tax exemp- finance. (The aggregate public sector deficit measures the tions. Temporary tax relief measures for domestic enter- excess of expenditures over current revenues for govern- prises associated with the 1994 tax reforms were stopped at ment plus state enterprises.) Between 1987 and 1993, the the end of 1995. Similarly, the government is contemplat- public sector deficit hovered around 11-12 percent of GDP ing eliminating import duty exemptions, tax holidays, and (with a peak of 13 percent in 1993) and was a key factor lower corporate tax rates for new foreign investors, with underlying inflationary pressures in the economy In 1994, suitable grandfathering provisions for existing investors. however, the public sector deficit declined abruptly to 9.9 Declining revenues as a share of GDP, and the desire to percent, easing pressures on financing, providing a greater keep the budget deficit in check, have meant strong pres- flow of savings for nonstate investment, and contributing sures to keep budgetary expenditures under control. Yet toward a current account surplus. Although full data for government policy decisions resulted in expansion of some 1995 are unavailable, initial estimates suggest that the pub- budget items. For example, the budget is still absorbing the lic sector deficit continued to shrink, albeit at a slower pace. 30 percent wage increase for all civil servants in 1994 8 Ti[E CIIINESE ECONONMY: FtGIHTNG INFLATION, DEEPENING REFORNIS TABLE 1.4 The aggregate public sector deficit, 1987-94 (percent of GDP) estimated 1987 1988 1989 1990 1991 1992 1993 1994 1995 Aggregate publicsectordeficit 10.7 10.7 1 1.4 12.3 10.9 13.1 12.7 9.9 8.7 Govemment budget deficit 2.1 2.4 2.3 2.2 2.5 2.6 2.3 1.7 1.7 State enterprise defiat 8.6 8.3 9.1 10.1 8.5 I 0.5 10.3 8.2 7.0 Total financing 10.7 10.7 11.4 12.3 10.9 13.1 12.7 9.9 8.7 Foreign borrowing 1.9 1.7 1.4 1.6 1.1 2.3 2.1 2.3 1.5 Net domestic borrowing 8.8 9.0 10.0 10.7 9.8 10.8 10.6 7.6 7.3 Issuance of debt securities 0.4 0.9 1.2 0.3 1.2 2.5 0.7 1.9 1.6 Banking system 8.4 8.1 8.9 10.3 8.7 8.2 9.8 5.7 5.7 People's Bank of China 1.6 3.9 1.8 1.2 0.2 4.6 3.4 -2.7 -3.4 Other 6.8 4.2 7.0 9.2 8.4 3.7 6.3 8.4 9.1 Note: See Annex 3 in Volume 11 for an explanation of the methodology underlying these calculations. Source: World Bank staff estimates. (retroactive to October 1993). Subsidies for agricultural lic (using treasury bonds). This shift was made possible, of trading enterprises increased in the wake of higher grain course, by a decline in investment demand by state-owned procurement prices in July 1994. And interest payments enterprises, reflecting the government's resolve to bring almost doubled in the first three quarters of 1995, reflect- inflation under control. One consequence of this shift will ing greater dependence on treasury bond financing of the be a pick-up in the growth of government debt over the deficit. To compensate, other expenditures were lowered in next few years. This will need to be watched carefully, espe- 1994 and 1995. For example, subsidies to cover the oper- cially in light of possible increases in real interest rates fol- ating losses of state-owned enterprises showed a decline in lowing reforms in the financial sector (see chapter 3). nominal terms in 1994 and 1995, maintaining a trend that had begun in 1990. And government investment expendi- Conclusion tures declined by 22 percent in nominal terms in 1994, so that despite expanding by about 28 percent in 1995, they China's success in 1995 in bringing inflation under control were still below their nominal level in 1993. without disrupting growth is a marked departure from pre- The intergovernmental fiscal arrangements introduced vious economic cycles. This performance reflects consen- in 1994 brought a sharp increase in the central govern- sus at the highest levels to combat inflation, growing ment's share in total revenues from 36 percent in 1993 to sophistication in macroeconomic management, and 56 percent in 1994. But the bulk of that revenue was increased resilience in the economy returned to the same provinces that collected it. Only a In the near term, the government faces the difficult task small share of the central government's increased revenues of keeping inflation below its target rate of 10 percent for was redistributed to poorer provinces. The government is 1996 while ensuring that economic growth is maintained in still studying different options for a more equitable inter- the 8-9 percent range. Balancing the need to keep inflation governmental grants scheme, but a decision has not yet low with the legitimate credit requirements of a growing been made. Regional disparities in fiscal depth are likely to economy will require flexibility in macroeconomic policies widen for some years to come, reflecting widening income during the year. The government needs to guard against disparities. policies that are so restrictive as to stall growth as much as Just as important as the decline in the public sector it needs to avoid the possibility of rekindling inflation by deficit has been a substantial shift in the financing of the prematurely adopting expansionary policies. deficit to noninflationary sources. Between 1987 and 1993, Over the medium term, the Chinese authorities still the public sector deficit was financed largely through the need to tackle deep structural problems that feed inflation- banking system. But 1994 and 1995 saw a contraction in ary pressures in the economy and that underlie a tendency borrowing from the central bank and a shift toward com- toward sharply fluctuating cycles. As the rest of this report mercial bank financing, and direct borrowing from the pub- suggests, resolving these structural issues of state enterprise RECENT ECONOMIC DEVELOPMENTS: STABILIZATION WITHI GROWnI 9 reform, financial sector development, and sound public 5. A change in the method for collecting export statistics finances will help sustain rapid growth into the future and added six days to the January 1995 estimate, leading to an facilitate greater reliance by government on indirect meth- unusually sharp spike in export earnings for that month. 6. Given some investment by Chinese firms in other coun- ods of macroeconomic management. tries, net foreign direct investment inflows are expected to be about US$3-4 billion less. Notes 7. The largest was Taiwan (China). 8. The latest revisions to the balance of payments for 1995 n.athese cownth arate arejasted fon ofaro al statistics. defi thenie, (see endnote 3) include a slightly lower estimate for errors and national accounts are adjusted for various statistical deficiencies, omissions. China's GDP growth would probably be about one to two per- 9. This shows in the monetarv survey as a big increase in other centage points lower (see World Bank 1994c). 2. The official poverty datum line upon which this estimate is 1tems (net). based is RB 324 per apita at 193 prices.10. Actual refund obligations exceed RMB 43 billion, but the based is RMB 324 per capita at 1993 prices. G~enetsrfn amnsaemaras 3. Just as this report was going to press, the authorities issued Government's refund payments are In arrears. preliminary revisions to the balance of payments for 1995. The new estimates show a significant reduction in the current account References surplus, largely owing to a sharp upward adjustment in profit remittances. Interpretation of these new estimates is difficult at Broadman, H. and X. Sun. 1995. The Distribution of Foreign this stage, especially as similar adjustments have not been made Direct Investment in China. World Bank, China and Mongolia to the balance of payments estimates for previous years and the Department, Washington, D.C. implications of these changes are omitted from estimates of UNCTAD (U.N. Conference on Trade and Development). 1995. GNP World Investment Report. Transnational Corporations and 4. The effective real exchange rate depreciation for exporters Competitiveness. Geneva: UNCTAD. was sizable because under the old foreign exchange system World Bank. 1994a. "China: Macroeconomic Stability in a exporters received a 10 percent retention quota, which entitled the Decentralized Economy" Report No. 13399-CHA, China and holder to the purchase of foreign exchange at the official rate for Mongolia Department, World Bank, Washington, D.C. import purposes and which could be sold at the swap market price. World Bank. 1994b. China: Foreign Trade Reform. Washington Another 70 percent retention quota accrued to local governments D.C.: World Bank and foreign trade corporations. Thus, from the point of view of World Bank. 1994c. "China: GNP per Capita." Report No. exporters, the unification depreciated the exchange rate signifi- 13580-CHA, China and Mongolia Department, World Bank, cantly. Further, the expanded access to trading rights increased Washington, D.C. competition and reduced margins for foreign trade corporations. World Bank. Various years. World Debt Tables. Washington, D.C. 10 TIlE CIIINESE ECONOMY: FIGHTING INFLATION, DEEPENING REFORMS Part II Structural reforms for rapid, sustainable growth The first chapter reviewed recent economic developments, entrepreneurial energies, and introduced competition focusing on China's success in lowering inflation without between domestic firms and from international trade. disrupting growth. The next three chapters ask how China Indeed, compared with other countries (especially the can sustain rapid growth in the medium and long run. Soviet Union) China's growth has been quite intensive Sustaining growth means more than just maintaining (figure A). rapid growth. It also means improving the quality of growth Consider the period 1985 to 1994, when average GDP while ensuring stability. This involves reforming the struc- growth in China was 10.2 percent. Two-thirds of the growth ture of the economy, building its institutions, and creating was the result of capital accumulation, supported by an an enabling environment for improvements in productivity extraordinarily high savings rate that has come to depend and efficiency. As government controls give way to market increasingly on China's thrifty households (figure B). Less forces, the role of Government itself would need to shift important, but significant nonetheless, have been increas- increasingly toward indirect methods of macroeconomic ing labor force participation rates. management. The ultimate objectives should be to create One-third of growth was the result of productivity adequate and remunerative employment for the labor improvements in the use of inputs, due to structural change force; eliminate the desperate poverty that plagues parts of across sectors and efficiency improvements within produc- the rural interior (and is surfacing in some cities); improve tion units (table A). The movement of labor from agricul- access to health and education, especially for women and ture to industry and to a lesser extent services contributed girls in rural areas; and protect the environment for future about l percentage point to aggregate GDP growth in the generations. These objectives serve to remind us why past decade. Another 0.4 of a percentage point was the growth is important in the first place. They also point to a result of resource reallocation between state and nonstate pattern of development that will help sustain growth over enterprises. The most striking feature of structural change the long term. in industry is the extraordinary growth of "private" firms- Growth in China since 1978 has been fueled by more privately and individually owned enterprises, foreign joint than the accumulation of capital. Economic reforms have ventures, and foreign-funded enterprises. This group played a key role. These reforms included substantial liber- increased its share of industrial value added from I percent alization of domestic prices, internal and international in 1984 to 24 percent in 1994, much of it in the past five trade, and the international exchange and payments sys- years. tem. Reforms also granted significant freedoms to agricul- Will these sources of growth be as powerful in the next tural households, nonstate enterprises, and local authori- decade as in the past? Probably not. For example, the ties through a gradual process of experimentation and dis- potential for productivity gains from reallocating labor semination of best practice. from agriculture to other sectors will diminish as surplus The introduction of market-based incentives con- labor in agriculture is reduced. Furthermore, it is difficult tributed to growth by encouraging rapid structural change to foretell the trajectory of China's savings rate. Savings away from low-productivity sectors toward high-produc- rates could decline, if for no other reason than that they are tivitv sectors. Reforms also encouraged structural change already high by international standards. Much will depend within sectors, as resources were increasingly absorbed in on the pace and pattern of growth, the availability of sav- more efficient nonstate firms rather than state enterprises. ings and investment opportunities, and the future direction Finally, economywvide efficiency gains were important, as of social security reforms. The projected deceleration of reforms improved incentives for production, unleashed growth in the near term and increase in China's dependen- 11 FIGURE A FIGURE B China is no Soviet Union China's thrifty households Capital output ratios of selected countries Urban and rural household savings as a percentage of GDP Capital output ratios Percent 5.0 25 4.5 20 singapore 5 3.0 2.0 7orea- t 4220t 5 1.0 0 1970 t975 1980 1985 1990 1978 1980 1982 1984 1986 1988 1990 1992 1994 Source Data for China, Korea, and Singapore from Nehru and Dhareshawar (1 993); for Source. World Bank staff estimates based on China Statistical Yearbook, various issues. Soviet Union from Easterly and Fischer (I1995): see Annex 4 for deta Is. cy ratio (ratio of non-working-age to working-age popula- ic management through indirect means rather than direct tions) over the longer term cast a subdued light on the out- controls, and to establish the rightful place of Government look for China's savings rate. in an increasingly sophisticated market economy If the savings rate declines, capital accumulation cannot It is these imperatives that underlie the central impor- be expected to generate the same growth impetus that it tance of reforming state enterprises, the financial sector, did in the past. But sustained rapid growth is critical to and public finances. The Government has already maintaining the decline in the number of poor, providing embarked on ambitious programs in all three areas. employment opportunities for a labor force growing at Progress has varied. Furthermore, being in transition has 13-14 million each year, and improving the incomes and complicated the task of macroeconomic management. So quality of life for China's immensely large population. This completion of these reforms will be crucial for sustainable places an added burden on the need to generate produc- growth and stability over the long term. By feeling the tivity gains in the economy and points to the importance of stones under the water, China is part way across the reform persevering with reforms that promote efficiency. river. The next three chapters in this report recount part of To achieve these productivity gains, the Government will the recent journey and indicate what more needs to be need to maintain the momentum of reforms in two strate- accomplished to get to the other side. gic directions. The first would place greater reliance on mar- ket forces, with special emphasis on state enterprises and TABLE A the financial sector. The second would stress restoring the Deconstructing growth in China, 1985-94 health of government finances and shifting the focus of gov- Sources of growth 1985-94 1985-89 1990-94 ernment expenditure policy toward such prioritv areas as GDP growth 10.2 9.2 10.2 health and education, reduction of poverty, infrastructure Contributed by development, and environment protection. Both sets of Factor accumulation 6.6 7.1 6.1 reforms are really investments in a system of laws, institu- Ownershipt reallocation 0.2 -0.2 .4 tions, and processes designed to encourage efficiency and TFP growth 2.3 1.4 3.2 technological progress, to facilitate effective macroeconom- Source: World Bank staff estimates; see Annex 4 for details. 12 TilE CIIINESE ECONOMY: FIG1ITING INFLATION, DEEPENING REFORMS Chapter 2 Reforming state enterprises: the unfinished agenda There is virtually complete agreement among China's poli- gregated data suggest otherwise. The relatively inefficient cxmakers that reform of industrial state enterprises is of the use of investment resources by state enterprises is evident highest prioritv The consensus is reflected in the speeches in thirty-seven out of the thirty-nine industrial sectors for of China's senior leaders and appears prominently in the which data are available (figure 2.1; see World Bank preparatory documents for the Ninth Five-Year Plan. It also 1995a). Value added per worker in industrial state enter- figures prominently in the fifty-point program announced prises is half that of nonstate enterprises, also suggesting by the Third Plenum of the Central Committee in lower levels of efficiency.1 If the accumulation of unsold November 1993, which called for development of a "mod- inventories of State-owned enterprises were deducted ern enterprise system" by 2000. from the valuation of output, value added per worker in The reasons are clear. Many of China's state enterprises state enterprises would sink even further.2 are inefficient and cannot compete against growing domes- Industrial state-owned enterprises as a group report oper- tic and international competition. This has made them a ating profits of 2 percent of GDP. But the number of loss- drag on growth and employment creation. The financial making enterprises has grown steadily, from 26.4 percent of support these enterprises receive through the fiscal and state enterprises in 1992 to 44 percent in 1995.3 The major- banking systems has periodically threatened macroeco- ity of loss-making enterprises tend to be below average in nomic stability. So their reform is essential to growth and size. In the first three quarters of 1995, for example, loss- stability. But the central position of state enterprises in the making enterprises accounted for 20.8 percent of industrial Chinese economy, their importance as employers of urban state enterprise production, 18 percent of sales revenues, but workers, and their role in providing social security, health, 41 percent of employees. Moreover, losses, although rising in and education services have complicated the task of absolute and real terms, have been declining as a share of reform. The government has made some progress in tack- GDP The largest loss maker is the coal industry, folowed by ling these thorny issues. But these accomplishments are defense, petroleum, nonferrous metals, and tobacco. only a beginning, and the most difficult and complex tasks Finally, the poor performance of industrial state-owned still lie ahead. Completing these tasks will be central to enterprises can be gauged by their relatively lackluster China's prospects for developing a modern enterprise svs- growth and employment record. Between 1984 and 1994, tem, ensuring macroeconomic stability, and further improv- for example, the growth of industrial output (in real terms) ing the economy's competitiveness. in state-owned enterprises was one-half that of nonstate enterprises and in 1994 alone it was closer to one-fifth. The problem Similarly, in the last decade, employment growth in nonstate enterprises has been three times faster than in state-owned Several indicators point to the poor performance of indus- enterprises although the output elasticity of employment trial state enterprises relative to the nonstate sector. For has been declining in both state and nonstate enterprises. instance, state-owned enterprises (SOEs) account for 34 The slower growth of state-owned enterprises has meant percent of industrial output but consume 73.5 percent of that their share in aggregate output and employment has industrial investment. As a result, the amount of capital been falling swiftly Their declining market share was ini- used for each unit of output in industrial state-owned tially assumed by collectively owned and township and vil- enterprises is more than twice that used by nonstate indus- lage enterprises in a second wave of industrial growth (the trial enterprises. This could be because state enterprises first wave was state-owned industrialization) that began are concentrated in capital-intensive industries. But disag- soon after reforms were initiated in 1978. In the past few 13 FIGURE 2 State enterprise performance... ... and reforms State enterprises use capital less efficiently.. Capital-output ratios of state and nonstate enterprises for thirty-nine industrial sectors Nonstate enterprises 6 Line of equality 1978-87: Central bank formulates general principles of 4 / I economic reform: law on joint ventures promulgated: price liberalization in agriculture begins: fiscal autonomy granted to local government: special economic zones created: private income tax introduced: price liberalization of consumer 2 / + goods begins: SOE reforms "tax for profits"' bank lending begins to replace SOE budgetary allocations: collectively owned enterprises encouraged: transformation of People's Bank of China into central bank begins; fourteen coastal cities 0 / * open up: township and village enterprises created. 0 2 4 6 Staie enter prises ...and their rates of return have been declining After-tax profits of state industrial enterprises as percentage of fixed assets Per-cent 25 d * 1988: SOE contract responsibility begins: Regulations on 0 Private Enterprise System published; Enterprise Law and Bankruptcy Law passed. I 0 4 1989: Regulations issued on mergers, joint stock companies, 5 and commercialization of banks. 0 1 973 1980 1982 1 984 1986 988 990 1 992 1 994 = 1991: Pension and housing r-eform begins; corporatization They have been losing market share... encouraged. Shares of industrial output Percent 00 * 1992: Deng Xiaoping tour of south: Directives on New 90 't -ttt ,' , ,' Operating Mechanism and Fourteen Autonomous Rights for 80 SQEs issued: phasing out of production tar-gets and price 7 0 t controls; steady progress on trade liberalization. 60 50 40_ 1993: Adoption of pnrciple of "socialist market economy"; 30 State o,ned enterpiises Decision of Third Plenum to establish "modern enterprise 20 system" by 2000. 10 1984 1985 1986 1987 1988 1989 1990 991 1992 1993 1994 ... and contributing less to employment creation 1994: Reforms of the foreign exchange and tax systems: reduction of budgetary subsidies to state enterprises; Shares of total nonagricultural employment launching of 10,000- 1.000- 100- 10 program; announcement Percent of industrial policy framework and creation of fifty-six 100 enterprise groups in "pillar" industries. Enactment of Company Law. 60 - 8' f l. ,8#Bl''.P.. 1995: Encouragement of mergers with nonstate firms: ., 3'3w3 'B 3~ 3.3 3 L B sg'3'3 3e3 3 3e'3^3'3B 32 t 8 { 8<8 3 3 establishment of mechanisms to clarify ownership rights of 40 - S ttf- i.a the state. 20 State-owned ente pr ises 0 1984 1985 1986 1987 1988 1989 1990 1991 J992 1993 1994 Source Chino StRovtircc Yec,book, various ssues World Bank 1995: PuNi,hc investment and Fmiance. Report No 14540-CHA. 14 TIIE CIIINESE ECONOMY: FIGIITING INFLATION, DEEPENING REFOKMS years, however, a third wave of industrialization has been ance of the Chinese people. The government has since building in China, comprising largely privately and individ- begun to reduce the deficit and shift its financing from ually owned enterprises, supplemented by joint ventures money creation to domestic borrowing. and foreign-funded enterprises. The startlingly swift rise of this third wave is an indication of the rapidity of change in The government's response the Chinese economy and has important policy messages, especially for the way financial resources are allocated by Concerned about the deteriorating trend in the finances of the financial sector (see chapter 3). state enterprises and the consequences for stability, the gov- True, the poor performance of state enterprises is partly ernment has been dealing with the reform of state enterpris- the result of constraints imposed by government policies. es in two ways. The first is by altering the policy environment Price controls, for example, depress state enterprise earn- in which they operate, notably by reducing subsidies through ings in coal, natural gas, fertilizer, and grain production. the fiscal and banking systems, but also by promoting com- Moreover, state enterprises are expected to provide social petition through increased trade, foreign investment and low security to their workers at their expense, including health, barriers to entry The second is by altering incentives within education, pensions, and unemployment benefits. Finally, firms by making management more autonomous and firms have little freedom to fire workers. Sixty percent of accountable, restructuring operations, diversifying owner- respondents to a World Bank survey of 156 state enterpris- ship, and reforming corporate governance. es chosen for reform reported that redundant workers Some progress has been made in curtailing subsidies to exceeded 10 percent of their workforce (World Bank state enterprise. Budgetary subsidies fell from 7.5 percent 1995b). Overall China's state enterprises employ an esti- of GDP in 1992 to 2.3 percent in 1994, and implicit finan- mated 15 million redundant workers. cial subsidies were more than halved, from 3.6 percent of State-owned enterprises' losses arising from policy dis- GDP in 1992 to 1.7 percent in 1994 (table 2.1). But tortions are partially offset by transfers from the budget progress remains limited. Subsidies continue to flow and implicit financial subsidies through the banking sys- through other channels, especially at the local government tem. In 1994, for example, budgetary subsidies amounted level, where the majority of state-owned enterprises are con- to 2.3 percent of GDP while implicit financial subsidies- trolled. For example, despite reforms in the banking system, in the form of low interest rate loans and unpaid principal working capital continues to find its way to loss-making and interest-came to another 1.7 percent of GDP The enterprises. Data to support these contentions are hard to survey of 156 state-owned enterprises (see above) showed find, but there is indirect evidence. Consider wage increas- that the transfers roughly equaled the costs to enterprises es in loss-making enterprises during 1995. These wage arising from government price policies, social security ben- increases closely matched those granted in profit-making efits, and wages for redundant workers. enterprises, yet labor productivity grew much more slowly in The deficit (or net financing requirement) of state the loss-makers (table 2.2). Such large wage increases in enterprises has become the hard core of China's aggregate loss-making enterprises would have been impossible with- public sector deficit, failing to register much of a decline out some support from the government or financial sector. since 1990. In 1994, aggregate net financing by state Some progress is also being made in altering incentives enterprises equaled 7.8 percent of GDP (table 1.4), within firms. The government's "10,000-1,000-100-10" reflecting weak after-tax earnings and a large investment program announiced in 1994 and the subsequent enact- program. In the past, the bulk of the borrowing require- ment of the Company Law in July 1994 provided an ment of state enterprises was financed by money creation. encouraging beginning.4 To encourage mergers, the gov- Yet China was lucky, because a substantial amount of erinment decreed that loans of acquired companies could seigniorage collected by the central bank helped limit the be paid by installment over five years and that accrued inflationary impact. Nevertheless, inflationary episodes interest prior to merger would be written off. To facilitate punctuated China's otherwise stable, but rapidly growing, bankruptcies, the responsibilities of enterprises toward economy. In 1993 and 1994 inflation reached hitherto laid-off workers have been clarified.5 The government has unclimbed peaks and severely tested the traditional toler- identified alternative mechanisms for restructuring enter- REFORMING STATE ENTERPRISES: TE IUNFINISI IED AGENDA 15 TABLE 2.1 Subsidies to state enterprises, 1985-94 (percent of GDP) 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Total 9.9 9.9 10.2 7.0 6.9 6.2 5.8 7.5 6.3 3.9 Through the budget' 7.5 7.5 7.2 6.4 6.9 6.4 5.2 3.9 3.1 2.2 Through the financial sector 2.4 2.4 3.0 0.6 -0.1 -0.2 0.6 3.6 3.2 1.7 a. nc udes price subsidies. Source: World Bank staff est,mates. TABLE 2.2 Shanghai, increased competition, lower budgetarv subsi- Wages and productivity of state enterprise dies, and tight credit have led to enterprise restructuring, (percentage change, January-September 1994 to 1995) downsizing, and some bankruptcies (see box 2.1). Up to Increase Increase in 1994, fifteen small and medium state enterprises within the inwages laborproductivity municipality had been declared bankrupt, and 130,000 Proft-makers 22.6 18.0 workers had been laid off. Shareholding experiments are in Loss-makers 21.3 2.1 full swing, whether to form cooperatives or to list compa- Source: Government authorit,es. nies on the Shanghai stock exchange. All state-owned enterprises and collectives participate in a pension pooling prise debt and is implementing these in some cases.' scheme covering 20,000 enterprises and 5 million people- Administrative mechanisms are being put in place to per- roughly 80 percent of Shanghai's workforce. An intera- form the custodial functions of the state. gency State Asset Management Commission, headed by a An industrial policy was announced in June 1994, vice mayor, oversees various state asset management com- under which fifty-six enterprise groups have been estab- panies that represent the state's interests on boards of lished in "pillar industries" (automobiles and automotive directors of shareholding companies. parts, petrochemicals, electronics and machinery, and con- In Harbin, ten unprofitable, debt-ridden industrial city- struction). The government is now designating major owned enterprises were shut down, and two small ones enterprises as dominant partners while encouraging small- were sold through auction; in t-wo other money-losers, man- scale enterprises to merge. The industrial policy initiative agers and workers were given control on a trial basis. In also provides pillar industries access to policy bank loans Wuhan, many unprofitable, small state enterprises have and additional protection from foreign competition. been closed or transformed into collectives. Another 148 Finally, at the Fourth Session of the Eighth National have been leased to various nonstate interests, including the People's Congress in March 1996 the government private sector. Of WVuhan's 288 state enterprises, the city announced its intention to concentrate on the reform and sold five that were declared bankrupt in 1994 and was development of 1,000 large state-owned enterprises and readying another seventeen for bankruptcy (eleven small enterprise groups that will form the core of China's modern and six medium-size). The city's property rights transaction enterprise system. At the same time, the government will center mediated mergers between fifty-five state enterprises loosen controls on the operations of China's roughly 90,000 and collectives. In Chongqing, two medium state enterpris- small industrial state enterprises. Reform in these enterprises es were declared bankrupt-a shoe manufacturer and a will be pursued through restructuring, mergers, leasing, per- knitting mill; the knitting mill was one of China's largest formance contracts, and sale to nonstate enterprises. bankruptcies, involving the layoff of 2,000 workers. From a nationwide perspective, however, these local gov- Experimentation by local governments ernment initiatives add up to only a modest beginning. Of 102,200 industrial state-owned enterprises, 474 have been Local governments are at the forefront of the effort to identified for bankruptcy since November 1994; of these, 92 reform state enterprises, and so practices, experiences, and have been declared bankrupt and 161 have initiated bank- outcomes tend to differ from province to province. In ruptcy proceedings.' But the government is gradually putting 16 TIlE ChIINESE ECONOMY: FIG]TING INFLATIO\N DFEPENING REFOIRMS BOX 2.1 Planting change in Shanghai The Shanghai municipal government has chosen thirty-nine of its Contributing to the Snanghai pension pool. state enterprises to participate in a comprehensive program for The Shanghai No. 3 Radio Plant is a younger firm. It was estab- reform. Two of these are the Shanghai Chemical Plant and the lished in 1960, following the integration of three smaller plants. In Shanghai No. 3 Radio Plant. They have different histories, but are the mid- I 980s, the firm made some profits from assembling reacting to the new forces of competition and commercialization in radios, televisions, and other low-end electronic products. But similar ways. They exemplify the challenges and opportunities that with increasing competition and a changing economic climate, loss- thousands of such state enterprises face throughout China. es emerged. Today, it owes more than it owns (excluding land and Founded in 1924, the Shanghai Chemical Plant is relatively old, But buildings). The pressure to change its ways has correspondingly it has been consistently profitable. It is the third largest firm in China been more intense. So, among other tnings, it has: producing plastics and film. Reform has come slowly to the plant, and * Declared 200 of its approximately I .300-person workforce it still reports to the Shanghai Chemical Industry Bureau. Nevertheless, redundant; 80 are to be laid off, and the remainder will retire or some changes have been introduced in recent years. They include: take extended sick leave. * Establishing a variety of commercial relationships with township * Subleased portions of its riverfront property to other domestic and village enterprises (7VEs) in rural and suburban areas, includ- and foreign investors and relocated some of its own facilities to ing joint ventures and subcontracting. cheaper, suburban locales. * Providing an increasing share of housing to its workers through * Formed separate accounting units, one of which has teamed up joint stock housing companies. with a Singapore firm in a joint venture. * Employing workers only on a contract basis: younger workers * Set up extensive relationships with TVEs, including capital have contract terms of three to five years. investments, loint ventures, land subleasing, and licensing and * Exploring joint venture arrangements with foreign firms from trademark protection agreements. the United States and Singapore. * Participated in the Shanghai pension pool. in place an infrastructure that should facilitate reforms. For pation in the reform process, local governments in these example, it runs 2,600 retraining programs to upgrade the cities now rebate 15 percent of income tax payments from skills of laid-off workers and 24,000 employment informa- state enterprises. Work has also begun on divesting enter- tion offices to help displaced workers locate jobs.8 There are prises of social security obligations and housing for work- thirty-six markets nationwide for 'property rights transac- ers. Local governments are encouraged to accept responsi- tions," with a national market planned for Beijing. These bility for running schools and hospitals previously run by markets mediate mergers and acquisitions among state state enterprises. Again, progress has been limited. Only enterprises and between state and nonstate enterprises. In two hospitals and twelve schools have been transferred suc- recent years, as many as 10,000 state enterprises have been cessfully, including three schools divested from the involved in mergers or acquisitions. Usually state enterprises Chongqing Iron and Steel Company. have merged with collectively owned enterprises, but some By the end of 1994, there were 4,850 shareholding com- have also formed joint ventures with foreign firms. panies in the industrial sector, accounting for only 4 per- Of one hundred firms selected for corporatization at the cent of industrial output and 7 percent of industrial assets. national level, sixty-one have been restructured under the About 170 companies were listed on the Shanghai Stock Company Law into shareholding companies with limited Exchange and another 110 on the Shenzhen Stock liability. The majority have the state as their major share- Exchange. More than 30 had received approval for listing holder. Some are government departments (for example, on foreign stock exchanges, of which a dozen are in Hong the Qingdao Administration Bureau for Light Industries is Kong and four in New York. now the First Light Industrial Company). In the eighteen cities chosen for comprehensive enter- The unfinished agenda prise reform, additional capital has been provided to increase production capacity and upgrade technology. To Notwithstanding such examples of enterprise restructuring help finance enterprise restructuring and motivate partici- at the local level, the task of improving the efficiency and REFORMING STATE ENTERPRISES: TIIE UNFINISIIED AGENDA 17 competitiveness of China's 102,200 industrial state enter- ment on the boards of directors of incorporated compa- prises has only just begun. In preparatory documents for nies. Finally, the government could also focus on granting the Ninth Five-Year Plan, the government has emphasized additional autonomy to managers of state enterprises.9 its determination to break the back of the problem in the The World Bank survey of 156 state enterprises chosen next five years. It recognizes that much remains to be done. for reform showed that managers often did not possess Reliable financial information on state enterprise perfor- the freedom to make basic management decisions, such mance, for example, is still hard to obtain. Reforms have as on the size and composition of the labor force, input yet to provide sufficient market-based autonomy and risk- and output mix, sales outlets and input sources, and vol- reward incentives to state enterprises management. Lines ume and sources of financing. of authority over property rights between government and Accelerate the transfer of pension, health, and education management remain vague and in some cases, fundamen- obligations from state enterprises to government authorities. tally unchanged. The erosion of government authority over The momentum of the enterprise reform program could many enterprise decisions has not been replaced by mar- suffer if the thorny issue of removing the burden of social ket-based incentive systems, giving rise to opportunities for sector expenditures from state enterprises is not resolved. asset stripping and opportunistic behavior by managers, These expenditures can constitute a large part of the total workers, and sometimes even local governments. Despite cost of labor (figure 2.2). It would be difficult to liquidate, some high-profile bankruptcies of state enterprises in sell, merge, or restructure enterprises if they were still recent months, there remains considerable reluctance on required to meet these obligations. As mentioned earlier, the part of government (especially local governments) to the government has already started creating pension pools shut down enterprises that have little hope of financial via- at the municipal level and earmarking payroll taxes to bility. Institutional and procedural hurdles make bankrupt- finance pension, health, and unemployment benefits. cy difficult, time-consuming, and costly. These reforms could be accelerated with the introduction China's state enterprise reform program operates at two of a pilot program that transfers these expenditure obliga- levels: an improvement in economic performance through tions to municipal governments. When national pension market discipline and an improvement in incentives within and health programs are created, these could be merged enterprises to encourage better performance by introduc- with those at the municipal level. During the pilot phase, ing appropriate systems of governance. It is important that the central government could provide supplementary fund- the Government intensify and accelerate this reform ing if the sale of assets of divested or liquidated firms was process within a clear and well-articulated strategy for insufficient to cover the increased liabilities of municipal improving enterprise efficiency and competitiveness. To governments. In this context, housing subsidies would also this end, we recommend three sets of policies that should provide the framework for developing a detailed program FIGURE 2.2 of enterprise reforms. Social sector expenditures constitute a large share For all state enterprises, implement programs to improve of the labor costs in state-owned enterprises govern7ance, diversify ownership, and lowver budgetary and (Percent of total labor cost) financial subsidies. A top priority is to implement the new Education Pensions 1%Hosn accounting system, because good governance and well- 21% Housing designed policies start from good information. In addi- Health tion, the development of a modern enterprise system requires the separation of management functions from ownership concerns-a difficult task in an economy where the government is both owner and manager. To accelerate this process, the government could set clear commercial objectives, lower subsidies to enterprises, Wage bill diversify ownership, streamline state asset management 56% bureaus, and clarify the agency representing the govern- Source. World Bank 1995b 18 TIlE CIIINESE ECONONM: FIGIITING INFLATION, DEEPENING REFORNIS need to be phased out, either by raising rents and wages Appropriate policies would include exposing these enter- simultaneously or by selling property rights to tenants. This prises to domestic and international competition (especial- is the largest component of social costs borne by enterpris- ly in export markets), granting greater management auton- es, and as long as housing is linked to firms, enterprise omy, diversifying sources of finance, and applying better reform will be difficult to move forward. regulations. Subsidies to these enterprises should be low- Further improve competition policies to encourage efficiency ered gradually. If the government is compelled to provide imnprovements in state enterprises. Part of the steady decline in subsidies, these should be limited, time-bound, and chan- the share of state enterprise output and employment can be neled through the budget rather then the financial system. attributed to increased competition from nonstate enter- Within these, the government's highest priority should be prises and imports. But much could still be done to intensi- enterprises delivering important public goods and services. fy competition further and heighten efforts to make state These include such subsectors as natural gas and electric enterprises more efficient. For example, the government power distribution, urban water supply, solid waste man- could eliminate interprovincial barriers to trade (especially agement, and railways. Here, the appropriate approach of foodstuffs) and expand the entry of nonstate domestic involves separating commercial activities from government and foreign investors into manufacturing industries and bureaus, clarifying the legal and regulatory framework for infrastructure (such as telecommunications, power genera- setting administered prices, and diversifying sources of tion, and oil exploration, extraction, and distribution). It finance by tapping domestic and foreign capital markets. In could phase out tax advantages offered foreign investors addition, wherever possible, the government's policies and thus not only remove a handicap that state enterprises should not restrict entry of new firms. Even though new (and other domestic firms) suffer, but also dampen the vol- firms may never enter these industries, the threat of entry ume of capital inflows that are posing problems in macro- itself tends to impose some discipline among existing mar- economic management. Similarly, eliminating interest rate ket participants. discrimination by class of ownership, together with a grad- Improve the efficiency of the 14,000 large and medium-size ual phaseout of the credit plan, would remove implicit enterprises by diversifying ownership, restructuring debt adjust- advantages enjoyed by state enterprises at the expense of ing operations, encouraging mergers and consolidations, and, if nonstate firms. Finally, as noted earlier, continued liberal- all elsefails, by liquidating. In some ways, this represents the ization and rationalization of the international trade and hardest task of all, because it requires judgments on which investment regime, including reduction of tariff barriers and firms have a financially viable future and which do not. phased elimination of nontariff barriers, would ease China's Preparing a strategy for firms with either heavy losses or entry into the World Trade Organization, sharpen the com- handsome profits should be relatively easy. But determin- petitiveness of state enterprises, and bring substantial wel- ing the fate of the one-third to one-half of enterprises that fare benefits to consumers (Bach, Martin, and Stevens are marginal will be more difficult, and will require the use 1995). of market forces and decentralized decisions. In applying these policies, however, the authorities will As in other instances, an important precondition is the need to pay special attention to the specific needs and cir- availability of good accounts based on modern internation- cumstances of particular types of enterprises and tailor their al standards, with independent audits and public disclosure interventions accordingly. To begin with, we would recom- for transparency Using these, local governments, together mend differentiating between three groups of enterprises: with local branches of banks, will need to distinguish inher- the Government's priority 1,000 large enterprises, about ently viable from effectively bankrupt companies. Even 14,000 medium and large industrial state enterprises that when social service provision has been transferred to local are not on the priority list, and the remaining 90,000 or so governments (see above) and appropriate internal gover- small industrial enterprises. For each of these, we would rec- nance structures are in place, fundamentally viable enter- omrnend the following: prises (expected to be about 8,000) may still need restruc- Use competition and governance policies, not subsidies, to turing, including labor shedding, financial engineering, and foster the efficient development of the Central Government's equipment retooling. The rapid growth of employment in priority 1,000 state enterprises and enterprise groups. nonstate industrial and service firms provides such enter- REFORMING STATE ENTERPRISES: TIIE UNFINISIIED AGENDA 19 prises a unique opportunity to prune their oversized labor Notes force without an unacceptable increase in the unemploy- ment rate, although some provinces and cities are likely to 1. The lower value added per worker could be due to lower cap- find this more difficult than others. ital-labor ratios, but this is unlikely As far as enterprise debt restructuring is concerned, 2. Inventory accumulation in China was 3.5 percent of GDP two guiding principles could be followed. First, debt in 1994, which was low by historical standards. In some years, it has exceeded 10 percent of GDP It is fairly safe to assume that restructuring should occur with a fully agreed future strat- these inventories have been accumulating mainly within state egy for the firm and a clear understanding that there will enterprises. be no future bailouts. This means that debt restructuring 3. The 1995 figure is as of the end of September. Only part of should be implemented only toward the end of the reform this increase in losses can be explained by adoption of the new process, once better accounting systems are established, accounting system. aprpraenplace, and expe- 4. The "10,000-1,000-100-10" enterprise reform experiment aropted govagernane iositrctu desaign . ' calls for: 10,000 large and medium state enterprises adopting rienced m a srnonew accounting standards byJtily 1995; 1,000 large state enter- the corporate strategy. And second, the burden of debt prises adopting the new state asset management regulations by restructuring should be shared by banks, local govern- Julv 1997; 100 large and medium-size state enterprises beingcor- ments, and enterprises. poratized as limited liability or limited liability shareholding com- Finally, nonviable enterprises should eventually be panies under the Company Law; and 10 (now 18) municipalities undergoing comprehensive urban enterprise reform, including bclsed and their assedts iquidated. thiso will costsfak stme 'state-owned enterprises restructuring, technology upgrading, because of the need to mitigate the social costs of adjust- mergers and consolidations, bankruptcy, and divestiture of social ment, establish the bona fides of claimants and the priority services. with which they will be paid, and ensure a fair and trans- 5. Laid-off workers who become self-employed and no parent process of asset liquidation. longer retain employee status may receive a one-off settlement Develop and systematically implement a program to transfer equal to three times the average pay received in the previous six months. If the worker cannot find a job or the one-off settle- all 90,000 small industrial enterprises to the nonstate sector t ment cannot be paid, then unemployment benefits are to be through sales, leases, or mergers. The government has already paid for a fixed period. If this period expires, and the worker is stated its intention to loosen controls on the restructuring, still unable to find a job, then responsibility for unemployment merger, lease, or sale of China's 90,000 small industrial benefits is transferred to the local department of civil relief. state enterprises. But the government should go further Bankrupt companies previously running social, medical, and and encourage the transfer of these enterprises to the non- retirement insurance plans are required to pay a one-off settle- ment to cover pension entitlements, burial expenses, and med- state sector through sales or mergers wtth nonstate firms. A ical copayments. program should be designed that systematically accom- 6. Enterprise debt restructuring mechanisms include: plishes this within the next five years. A first phase could * Debt-equity swaps, in which government claims against enter- see a pilot program launched in the eighteen reform cities, prises are converted to government equity, interenterprise claims with the objective of selling 20,000 small state enterprises are converted to equity, and claims of nonbank financial institu- in two years. Once lessons from this program are absorbed, tions are converted to equity Ownership of bank claims would first have to be transferred to brokerage firms before they could the government could accelerate the process inmthe next be converted to equity three ears. One priority, apart from establishing the * Suspension of interest payment and temporary suspension of machinery of implementation, is to decide on how sales amortization, which would cover enterprises making losses on proceeds will be divided between the central and provincial account of special government policies and enterprises imple- governments. In any event, the proceeds of such asset sales menting government-sponsored projects in high priority sectors. will first need to be applied toward funding pension liabii- * Writeoffs and exemptions of bank loans cover bankrupt ties transferred to municipal governments (see above), enterprises and can be set against dead loan reserves or bad loan tles transrerred o mumclpal governents (sreserves. Another priority would be that all firms to be sold would 7. An estimated 2,000 firms (of all ownership types) have need standardized, audited accounts, and all assets and lia- applied for bankruptcy since the Bankruptcy Law was promul- bilities would need to be quantified. gated; half of these have already been declared bankrupt. 20 TIlE CIIINESE ECONONM\. FIGHTING INFLATION, DEEPENING REFORMS 8. Despite their numbers, these offices cannot cope with the References demand for their services. The retraining programs have retrained 1.2 million unemployed so far, which is in addition to 3.2 million Bach, C. F., W Martin, and J. A. Stevens 1 995 "'''hia an.c' thc being retrained in schools and universities. The employment %XCTO: Tariff Offers, Exemptions, and(1 Welfare lmphicat.ons. information offices have helped 13 million jobseekers find jobs International Trade Division, International Econor-m. over the years. But these offices are plagued with inadequate and Department, World Bank, Washingtoni, D.C. outdated information, are slow in responding to individual Easterly, W and S. Fischer. 1995. 'I'lhe Sov.et Ecron-):L requirements, and are not integrated into a citywide. let alone Decline " The World Bank EcoJomJt Ret!vu' 9J 1 nationwide, network. 341 -7 I 9. Of the fourteen autonomous management rights, however. Nehru, V and A. Dhareshwar. 1993. A N-w t;_taw sc I the "right to transfer assets" appropriately belongs with the owner Physical Capital Stock: Sources, MecLnodolugv: and Rcsults~.' (the government) and not with management. Revztta de Analisis Econonmico 82 1 )I. --5i. World Bank. 1995a. "Chinra: Public Investirmnt anr f: n Report No. 14540-CHdA, China and M1cc;goiha r:.auimcn World Bank, Washingion, D.C. World Bank. 1995h. "China: Roitn. .,. ii ai..:.n Enterprises." China and Mongolia Dt-partnerr . XX.rid . Washington, D.C. (forthconnin,r. REFORMING STATE ENTERPRISES: TIIE UNFINISIIED AGENDA 21 - | L Chapter 3 Financial sector reforms: major issues and policy options This report makes a case for structural reforms on the entire financial sector, including strengtheniing the central grounds that they will help improve economic efficiency, bank and creating special arrangements for directed pohcy- sustain growth, and create conditions in which indirect related lending (see below). These reforms reflect the gov- methods of macroeconomic management can be effective. ernment's recognition that its central role in directinig Chapter 2 noted the importance of state enterprise reforms financial resources through the bankinig svstem is less in achieving these objectives. This chapter highlights the appropriate, while acknowledging the need For some need for progressing rapidly with reforms of China's finan- finance to serve policy purposes for the foreseeable future. cial system. The issue in China is not the need for financial sector A sound financial sector will be crucial for maintaining reform, but rather its design, the type of measures needed, rapid growth in China. Research findings show that well- their speed and sequencing, and their coordination with functioning financial systems tend to stimulate and sustain reforms in the rest of the economn.i These are difficult ques- growth because they help pool financial savings and allocate tions, made more complex by enormous challenges cot- them to the highest return use subject to appropriate safe- fronting the financial sector. The parlous condition of state guards (King and Levine 1993). In China, however, the finances has placed a growing burden on banks to fund financial system does not do this very well. Although the state-directed investments and to extend working capital recent proliferation of nonstate firms has improved efficien- loans to loss-making state enterprises at government- cy in production and substantially increased employment determined interest rates. The result is a banking syslem outside of agriculture, the government's investment and with limited banking skills and a high proportion of non- credit plans continue to steer the bulk of financial resources performing assets; a central bank with insufficient experi- toward state enterprises. Meeting the investment targets and ence in monetary management, few policy instruments, credit needs of state enterprises has often overshadowed and inadequate regulatory and supervisory capacitv; and a other macroeconiomic policy considerations, leading to reg- highly volatile capital market. ular bouts of overheating and subsequent retrenchment. This chapter briefly reviews recent progress in reforminig China's government-directed banking system exists side China's financial system, examines key financial scctor by side with an increasingly free market for goods, a rela- issues that remain unresolved, and maps the broad featmires tively smooth market-based foreign exchange system for of the task ahead, giving special attention to the important current account transactions, and a thriving and underregu- question of reform sequencing. lated nonbank financial system. This juxtaposition of a con- trolled banking sector at the heart of a rapidly reforming Recent progress in financial sector reforms economy has generated tensions withini the banking system, complicated macroeconomic management, and slowed the Considerable progress has already been made in setting structural transformation of the economy. But each previous the foundation for a modern financial system. China's attempt at liberalizing the financial sector has not only financial system today bears little resemblance to its pre- accentuated macroeconomic instability owing to weak cen- decessor before the reforms began in 1978. The tral bank controls, but has also shifted investment in a direc- monobank system of the pre-1978 era has metamorphosed tion deemed undesirable by the government. into a diverse set of institutions akin to the financial sys- The experience gained from these episodes culminated tems of middle-income market economries (table 3.1). At in the November 1993 decision to embark on a gradual, its core is the People's Bank of China, "established" in more ambitious program of reform across virtually the 1984 as a separate central bank responsible '-or monetar, J3 IABLFE 3. i China's financial system at a glance: structure ... ... and reforms Number Total assets of branches (RMB billion) Bkanking system 9 1978: People's Bank of China separated from Ministry of Finance. '-ople's Bank of China 2.529 1,758.8 4 a 1979: People's Construction Bank of China and 'olcy banks Agricultural Bank of China reestablished; China .... /eioprner eank of tuna 90.8 International Trust and Investment Corporation founded. 'ij'r-al B)ev&no'nent Bank of China - 406.9 The "Four Transformations" and Eight Reforms xix!.- miirwrt Bank o' China 2.5 Promulgated. Srttr-c r- erci. banks 1981: Resumption of Government Dcmestic Bonds issue. a...'a---''r -- .,ercial Bark of China 37,039 2,633.9 1983: State Council decides to separate People's -tpric.j'N, ai Bank of China 63.816 1,253.1 Insurance Company from People's Bank of China; cfanrk o; China 12.630 1.837.9 Industrial and Commercial Bank of China to take over "-cpier pl Construction Bank of China 33.979 1,397.5 commercial banking business of PBC. Nationwide commercial banks Bark of Communications 1,937 305.0 C 2na Trust and Investment Corporation 1987: Bank of Communications reestablished; Urban "Idusrrial Bank 54 70.7 Credit Cooperatives, Trust and Investment Corporations China E"erbright Bank i 2 20.3 and Finance Companies formally established. : i n a Xia Barik n.a. 1996) 82.9 1988: Secondary market for treasury bonds starts. '1:r. r !ier g (opening eady ! 996) -n.a. tine, commercial banks 1990: Cutback in number of TICs, Finance Companies: ; - a.ent Bark 31 44.5 Recognition of Shanghai Security Exchange. .;n½dcrg Development Bank I1 43.1 e eloment Bank n.a. 15.4 W"&ng Dr)i/'lopment Bank 18 17.8 1993: Third Plenum ofthe 14th Central Committee of Shc-,zhen Merchants Bank 9 44.7 the Communist Party of China adopts its November Ja,in lno -ci'n ! 8dank 7 19.8 "Decisions." announcing an acceleration of financial sector Y.nt,r 4-'u"i' ' Saving Bank s n.a. reforms. Main elements include: more independence for Berrgbu Housing Saving Bank n.a. na. the People's Bank of China; greater interest rate flexibility; commercialization of specialized banks: establishment of Nonbank financial institutions policy banks; and payments system development. Rural Credit Cooperatives 50,745 505.3 1994: Budget Law passed by the National People's Urba,i Credit Cooperatives 5,229 214.8 Congress, prohibiting government borrowing from the irust and investment companies 391 n.a. Central Bank. Establishment of State Development Bank; People's insurance Company of China 5,240 66.1 ExportAmport Bank: Agricultural Development Bank. Chirna Pacific insurance Company n.a. 4.2 "inarce compal ies 29 27.6 1995: Adoption of the Law on the People's Bank of Fir ancia! ;easing companies 11 n.a Ch na and the Commercial Banking Law. Sec rit-es comoEanies 87 n.a.I S January 1996: Establishment of national interbank market Mutual fund companies 43 n.a. with liberalized interest rates. Announcement that open Foreign financial institutions (representative offices) market operations will commence from April 1 1996. Foreign banks 250 n.a. Foreign finance co-npanies 4 n.a. Foreign investment companies 7 n.a. Foreign insurance companies 70 n.a. Foreign securities companies 40 r.a. Foreign credit card companies 4 n.a. Other- 18 n.a. Note. Data are lor 994. - is none. n.a. is nor available Source Pecp e's Ba-k of China. 1995. China s Financiai Outlcok Cnnnc Siaes:ical Yearbook 1995; Almanac of China's Finance and Banking 995. 24 TIIE CHINESE ECONOMY: FIGIInING INFLATION, DEEPENING REFORMS policy and supervision of the financial system. Dominating * Approved the Central Bank Law, Commercial Banking the banking system are four huge state commercial Law, Negotiable Bills Law, Insurance Law, and Guarantee banks-created initially as specialized banks for separate Law. The Central Bank Law gives the People's Bank of sectors of the economy-and three new policy banks set China the legal right to formulate and implement monetary up in 1994 (see below). In their shadow are thirteen small- policy and the sole authority to control and supervise the er commercial banks, most of them established in the last financial system. It also forbids the central bank from six years. At the edges is a strong and growing competitive extending overdrafts and direct loans to the centrai or fringe of nonbank financial institutions that has emerged provincial governments. The Commercial Banking Law as a force in recent years, including thousands of rural and requires banks to hold capital equivalent to 8 percent of urban credit cooperatives operating like banks, and an their risk-adjusted assets, restricts banks from lending more expanding presence of foreign financial institutions in the than 10 percent of their capital to any single borrower, and form of representative and branch offices. Completing the prohibits banks from extending uncollateralized loans to financial system are two securities exchanges at Shanghai relatives of staff. It also explicitly requires banks to develop and Shenzhen, seventeen regional securities trading cen- asset-liability management skills through appropriate ters, two electronic securities trading networks (STAQS programs and to maintain internationally accepted financial and NETS), and myriad ancillary capital market institu- accounting standards. tions including brokers, dealers, and underwriters. * Adjusted interest rates more frequently and eliminated pref- In November 1993, the Third Plenum of the Fourteenth erential sectoral lending rates. Since November 1993, the Party Central Committee set the future course of financial central bank has raised lending rates four times as part of a sector development in China, calling for: broader package to cool the economy. In addition, prefer- * Transformation of the People's Bank of China into a ential lending rates to thirteen sectors were eliminated in modern central bank responsible for monetary policy and January 1995 in an effort to rationalize the structure of supervision of the financial system; interest rates and give clearer signals about government • Separation of "policy" lending from commercial lending;' priorities. - Gradual transformation of specialized banks into com- * Granted some autonomy to state commercial banks in lend- mercial banks; ing decisions. Although the credit plan was strictly enforced * Separation of commercial banking from securities in 1994 and 1995, state commercial banks were granted trading; increased autonomy in making investment lending deci- * Controlled development of nonbank financial institutions sions within their individual credit ceilings. State commer- and capital markets to complement the banking sector; cial banks already possess some autonomy in extending * Modernization of the infrastructure of the financial working capital loans, which account for 60 percent of the sector. credit plan. But their freedom to allocate investment loans Since then, reforms in the financial sector have accelerated. had been circumscribed by a detailed lending program I the last two years, the government: drawn up by the State Planning Commission in consulta- * Created three policy banks to separate policy lending from tion with the central bank, the Ministry of Finance, and the commercial lending. These banks are now operational. Their State Economic and Trade Commission. Now, with the financing was secured by capital and other contributions establishment of the policy banks in 1994, the state com- from the government, financial bond placements with state mercial banks are being granted a measure of autonomy in commercial banks, and borrowing from the international their decisions on the investment lending program and are financial markets.2 Although state commercial banks were gradually gaining some independence to pursue commer- expected to transfer their existing stocks of policy loans to cial objectives . the policy banks, no assets have been transferred to the * Introduced asset-liability ratios for nationwide commercial State Development Bank of China or the Export-Import banks as an instrument of monetary management to comple- Bank of China, giving them a strong portfolio position at ment the credit plan. In its endeavor to gradually move away the outset of their operation. from the credit plan as the key instrument of monetary FINANCIAL SECTOR REFOR,MS: NWOR ISSUIS AND POLICY OPTIONS 25 management, the central bank has introduced asset-liabili- the banking system (described in the previous chapter) will ty ratios as an additional instrument of control over lending serve to strengthen and underpin the changes being con- by nationwide commercial banks. Regulations require that templated for the financial sector. each bank keep its lending volume below its credit quota or Phasing and sequencing of financial sector reforms will keep the loan-deposit ratio below 75 percent. This is be crucial for their success. Because it is difficult in this expected to encourage nationwide commercial banks to report to describe full details of the phasing and intercon- mobilize deposits.3 nections between different policy recommendations, a * Unified the interbank market and liberalized interbank matrix has been created (Annex 1 in Volume II) to show lending rates. These actions, taken in January 1996, are the visually how the myriad actions needed in the financial sec- first step in a longer-term program of interest rate reforms tor fit together. Seven critical areas require attention in the and an important element in setting the stage for open financial sector. These are discussed below, along with rec- market operations. ommendations for addressing them. In addition, the government has announced decisions to modernize the payments system; sever ownership links The credit plan between banks and nonbank financial institutions; initiate open market operations on April 1, 1996; extend the book- Key issue. The government continues to play an unusually entry system for government securities; and convert urban important role in determining the allocation of credit by credit cooperatives into urban cooperative banks in thirty commercial banks This involvement is in sharp contrast to cities. the government's reduced role in many of the real sectors T'hese reforms and announcements are impressive in in the economy, where reforms now permit market forces a their coverage and intent. The government now faces the larger role in allocating resources. The credit plan (in con- challenge of ensuring their effective implementation. But junction with the budget) is mainly how the government even these wide-ranging measures represent only the influences the level and pattern of investment in the econ- beginning in what promises to be a long, difficult, and com- omy and maintains control over the direction of industrial plex reform process. China's financial system still faces development. Although diminishing in importance deep, inherited structural problems that have been exacer- (accounting for only a third of total investment finance in bated by weaknesses in its fiscal system. At the same time, 1994) and becoming increasingly ineffective as a tool of development of the country's institutional capacity and monetary management (see chapter 1), the credit plan nev- human capital has understandably failed to match the ertheless remains a key lever of government policy. It gov- growing demands of a financial system that is expanding erns each bank's credit volume directly (in aggregate, by rapidly in size, diversity, and sophistication. different types of lending, and sometimes by different sec- Ultimately, the financial sector will need to mobilize and tors, subsectors, and even individual borrowers), and trans- allocate resources in an efficient and prudent manner, to lates the government's investment plans into reality. The support rapid, stable, and sustainable growth, better achievement of investment targets by the government has employment opportunities, and an improved quality of life come at the cost of deteriorating loan portfolios in the for the population. Achieving this will be a long, complex banks. In many instances, the creditworthiness of borrow- process. It will require not just policy changes but institu- ers and the commercial viability of projects were not impor- tional and human resource development in areas as diverse tant considerations in lending decisions. The government as banking and accounting, the judiciary, government, and estimates that about 20 percent of the assets of the state public finance. In addition, financial sector reforms will commercial banks are nonperforming.4 need to be carefully synchronized with reforms in other The establishment of policy banks and the intended sectors of the economy. For example, the pace of financial transformation of the specialized banks into genuine sector reforms will be influenced by state enterprise commercial banks are critical steps in the reform of the reforms, since the financial health of one affects that of the financial sector. The policy banks are there to ensure that other. Measures to commercialize state enterprise opera- state-directed lending does not interfere with commercial tions and end their dependence on subsidized credit from banking activity and that the costs of state-directed lend- 26 TIlE CIhINESE ECONOMY. FIGHTNG INFLAnON, DEEPENING REFORMS ing (interest rate subsidies, or nonrepayment of loans) are effective use of monetary policy. The ubiquity of govern- assigned to the budget. This objective cannot be achieved ment is equally apparent in the determination of interest immediately, however. It may take a few years before pol- rates. In all, the government sets over 200 interest rates. In icy banks have the resources to shoulder all policy lend- some instances, interest rates are set within a band around ing, so state cofmmercial banks will need to bear some of a reference rate, with band widths varying by type of finan- the burden in the interim. But, as noted already, in the cial intermediary and the creditworthiness of the borrower. short period since the establishment of policy banks, The level of interest rates, especially lending rates, is commercial banks have been granted increased autono- gradually becoming an important tool for managing aggre- my in designing part of their investment lending pro- gate demand. In recent years, however, low and often neg- grams within their assigned credit quotas (although ative real interest rates contributed significantly to rapid approvals by the State Planning Commission and the increases in investment expenditures,complicated the task State Council are still needed). of aggregate demand management and encouraged rela- Recommendation: Give commercial banks increasing tively capital-intensive production in enterprises with autonomy in allocating loans. Letting commercial criteria access to bank credit. At the same time, however, the vol- and market forces guide more of the allocation of financial ume of bank deposits has grown swiftly and inexorably resources will require a phased withdrawal of government. over the years. This reflects China's high savings rate, While the longer-term aim would be to abolish the credit strong public confidence in the banking system, and the plan altogether, this must be done gradually to allow state dearth of alternative financial assets for most institutional enterprises time to adjust to the new policy environment. and household savers. The unusually rapid growth in bank In the next two years (the short term), the government deposits over the past two years also owes something to needs to further reduce the scope and detail of the credit the reintroduction of inflation-indexed deposits for house- plan covering the state commercial banks. For example, holds; the unusually large differential between interest state commercial banks could enjoy complete autonomy in rates in China and Hong Kong, which may have encour- preparing their lending programs for fixed asset invest- aged some capital inflow (see below); sluggishness in the ments, by, say 1997. Similarly, project-by-project lending stock market; and uncertainty about the effects of enter- details requiring the approval of the State Planning prise reform. Commission and the State Council could cover less than The structure of interest rates reflects government pri- half of the 1997 credit plan covering these banks and less orities on resource allocation across sectors and types of than a third of the 1998 credit plan. Allocating the remain- borrower and incorporates some recognition of a positive der should be left to the state commercial banks. Here, yield curve. But China's interest rate structure is unduly too, the government could maintain some influence, if it complex, often obscuring real economic priorities. Until desires, by placing ceilings (for example, not more than 10 recently, virtually all sectors received some loans at prefer- percent of aggregate loans to real estate) or floors (for ential or differential lending rates. Even now, after the example, not less than 20 percent for agriculture), although elimination of preferential lending rates for thirteen sec- even these less stringent limitations could be eliminated tors, the number of special lending rates is large, creating over time. In the medium term (three to five years), state incentives for borrowers to spend time and money to commercial banks should be free from most credit plan secure these preferential rates from banks. restrictions, and all government-directed lending for Margins between lending and deposit rates tend to desired policy objectives could be undertaken through the fluctuate, and on several occasions deposit rates have policy banks or the budget. exceeded lending rates of similar maturity (table 3.2 and figure 3.1). Today, because three-, five-, and eight-year Interest rate policy deposit rates are linked to inflation, they exceed the rates for loans of similar maturity by a handsome margin.5 Key issue: government controls on interest rates will even- Partly as a result, three of the four state commercial banks tually arrest the development of the financial sector, had pre-tax losses in the first half of 1995, for the first impose high costs on parts of the economy, and hamper the time in their short history. Other factors behind these FINANCIAL SECTOR REFORMS: MAJOR ISSUES AND POLICY OPTIONS 27 FIGURE 3.1 the probable consequences. For example, the proximity of Comparing the one-year deposit and lending rate Hong Kong makes China's capital account relatively with inflation, 1982-9S porous. So it is quite probable that capital flows between Percent a year 30 the two economies (through the neighboring province of 2 (tweUmRaonthchangeation Guandong) respond to interest rate differentials (adjusted -" (twelve-month change In 25 ,' , the retail price index) for expected movements in the exchange rate). It is inter- 20 |, esting to note that China's official interest rates have loose- ly followed interest rates in Hong Kong, with China's inter- Is i , i est rates higher by several percentage points in recent years Ore-year fixed Chias 1 0 One-year asset rate (figure 3.2). In the last two years, China's deposit rates deposnt rateI. r , depotit rate must have seemed attractive to Hong Kong savers, and s " / , ' '' Hong Kong lending rates must have seemed attractive to 0 Ja a mainland Chinese borrowers, especially since the renminbi 1983 1999 1 197 1 989 J 9 993 Jan strengthened against the Hong Kong aoilar during this Source: People's Bank of China; Chmno Staoistical Yearbook, various years. period. This must have played a pari in the capital inflows the Chinese economy enjoyed, although it is difficult to losses include excessive expansion of bank branches and estimate precisely how much. spiraling increases in operating costs (especially salaries Recommendation: Reform interest rate policy gradually, and bonuses and the price of rented real estate). These beginning by rationalizing the structure and ending with losses were incurred despite the fact that many banks full liberalizaticn. Interest rate reform is a complex and treat accrued interest as paid income, provision negligible sensitive policy issue and needs to be approached with con- amounts for bad debt (in accordance with instructions siderable caution. International experience has demon- from the Ministry of Finance), raise the implicit return on strated clearly that while interest rates can be deregulated loaned funds through various unofficial add-on fees and quickly and seemingly easily, considerable financial disrup- service charges, receive substantial interest on their tion can follow if deregulation is not based on a foundation excess reserves deposited at the People's Bank of China, of adequate institutional and policy preparation. Thus, and often require low-yielding compensating balances while deregulated interest rates are an important and desir- from their borrowers. able objective, they should await the final stages of finan- Alongside controlled interest rates in China's main- cial reform process, after progress has been made in laying stream financial sector are freely determined interest rates such a foundation (see box 3.1). A liberalized interest rate in the capital market, in the informal sector, and in the off- policy functions best when: shore financial system in Hong Kong. These market-deter- * Macroeconomic conditions are reasonably stable. mined interest rates provide useful benchmarks to assess * Banks generally have positive net worth and can be whether official interest rates are unduly low (or high) and expected to remain solvent. TABLE 3.2 Interest rates at the longer end of the maturity spectrum (annual percent) March August November January March May July September Maturity 1994 1994 1994 1995 1995 1995 1995 1995 Indexed deposit rate Three-year 13.43 16.51 18.81 22.08 24.11 24.51 25.25 24.88 Five-year 16.13 19.21 21.52 24.78 26.81 27.21 27.95 27.58 Eight-year 18.83 21.91 24.21 27.48 29.51 29.91 30.65 30.28 Fixed asset investment loan rate Three- to five-year 13.86 13.86 13.86 14.58 14.58 14.58 14.58 15.12 Five- to ten-year 14.04 14.04 14.04 14.78 14.78 14.78 14.78 15.30 Source: People's Bank of China. 28 TIlE CIIINESE ECONONM' FIGITING INFLATION, DEEPENING REFORMS * Bank staff are well trained in modern financial tech- FIGURE 3.2 niques and in identifying creditworthy loan applicants. Higher deposit rates on the mainland * Financial markets are contestable. (One-year deposit rates in percent per year) * The real sector's financial health is good. 12 Chin * The central bank's supervision is skilled and incisive. 10 * The payments system is well developed. 1 * The audit and accounts system is of high quality. While the Chinese authorities have made considerable 6 progress in all these areas, these foundations need to be 4 strengthened further (see below). The weak financial health Hong Kor of segments of the state enterprise sector, the unknown sta- 2 tus of banks' portfolios, and China's history of government _ regulation in most aspects of financial resource allocation Jan Jan Jan Jan Jan Jan Jan Jan Jan 1 987 1 988 1 989 1 990 1 99 1 1 992 1 993 1 994 1 995 suggest the need for considerable caution in introducing 197 98 189 90191I2 93 I4 S suggest te need fr consideable cauion in inroducing Source: People's Bank of China and Hong Kong Monetary Authority. interest rate flexibility. At the same time, the need for cau- tion should not be an excuse for delay. Delays in interest rate reforms will continue to impose high costs on parts of around the country. Changing conditions make short-term the economy, arrest the development of the financial sector, recommendations difficult, but the current benchmarks and hamper the effective use of monetary policy suggest that lending rates could be raised slightly, even Given the close connections between different branch- though inflation is falling rapidly, while deposit rates could es of the financial sector and between the financial sector be lowered marginally. The higher intermediation margin and the rest of the economy, the sequencing of interest rate that would result could be used to increase provisioning policy reforms will determine the success of the outcome. against bad debts. For this reason, we propose that the government quickly * Fourth, the central bank's interactions with the banking phase in interest rate reforms that reduce the most egre- system, particularly when injecting or withdrawing liquidi- gious distortions and subsequently extend greater freedom ty, will need to be transacted increasingly at market-based to market participants in stages. These steps could include interest rates. The authorities at the People's Bank of the following: China have already indicated that they expect to proceed * First, the government could immediately reduce the with open market operations in April 1996. Similarly, the number of officially determined interest rates from over People's Bank of China will need to reconsider its policy of two hundred to fewer than thirty-roughly five deposit offering relatively attractive interest rates on all excess rates, ten lending rates (five each for working capital and reserves of banks. fixed asset lending), five rates for loans and deposits with * Fifth, the government could consider increasing flexibil- the Central Bank, and the remaining ten rates to be dis- ity in lending (not deposit) rates provided it is satisfied with tributed among classes of special loans or markets. progress on commercialization of the specialized banks, the * Second, the pricing of treasury bonds should be increas- level of competition in the domestic banking system, and ingly driven by market forces, partly to ensure that the gov- the quality of the People's Bank of China supervision (see emnment can sell the required volume of bonds, but also to below). The government could choose two ways to intro- secure the best price for government debt short of resort- duce flexibility gradually: first, it could allow commercial ing to administrative placement. banks to set their own interest rates on loans on a small * Third, interest rates could be set more actively, perhaps proportion of their asset portfolio (and this proportion quarterly or more frequently if conditions warrant. The sec- could be increased with time); and second, it could increas- ondary market yield on government debt is one benchmark ingly widen the bands within which interest rates are the government could use as a guide when setting interest allowed to fluctuate. rates. Other benchmarks could include interest rates * Finally, the government could introduce greater flexibil- charged in the informal, unregulated financial markets ity in deposit rates, but only after it is satisfied that the net FINANCIAL SECTOR REFORMS: MAJOR ISSUES AND POLICY OPTIONS 29 BOX 3.1 Preconditions for interest rate liberalization: five lessons from international experience A wide range of countries have reformed their financial systems ing of domestic and intemational economic developments. In and liberalized interest rates in recent years. These experiences Malaysia, where financial reforms were introduced successfully, have been analyzed at the World Bank and elsewhere. From this banks were given full autonomy over a large part of their loan port- body of research, five lessons on preconditions for interest rate lib- folios for the entire decade pror to the reform. In Indonesia and eralization emerge that could be useful to Chinese policymakers in New Zealand, banks were given time to improve their skill base their deliberations on the future of interest rate policy: before new entrants were allowed into the banking system, * The real sector should be financially sound. Financial although the presence of some foreign banks compensated in part reforms have progressed most smoothly where the net worth of for the shortage of skills in domestic banks. borrowers has been positive and their cash flow strong. The * Regulatory and supervisory standards should be Korean authorties, for example, maintained their control over lend- high. Bank supervision needs to shift from a passive check on ing rates until well after the 1979 oil price shock, the large devalua- compliance with government lending guidelines to a prudential tion in 1980, the start of the trade reform, and a significant decel- review of banks' risk management systems for the successful func- eration in inflation. By starting the process of interest rate liberaliza- tioning of a financial system with deregulated interest rates. This tion later than other reforms, and by going slowly, the Korean shift requires a well-developed regulatory framework and high authorities allowed banks and their borrowers to work out their quality supervisory standards. But bank supervision alone cannot nonperforming loans and adjust to new economic conditions and defend against unsafe lending practices. Requiring high levels of consequently to benefit from healthier corporate balance sheets. bank capital and encouraging liberal loan loss provisions would give * Banks should have positive net worth. When interest bank managements sufficient incentive to police themselves. Bank rates are liberalized and govemment is not prepared to see a bank go supervision then becomes a backup support to bank management. bankrupt, managers of insolvent banks have every incentive to offer * Governments must be prepared to Introduce inter- excessive deposit rates to maintain liquidity and then to extend larger est rate deregulation gradually. Interest deregulation needs to and riskier loans at even higher lending rates to cover their costs. The proceed in stages with complete deregulation awaiting later stages best course of action in such instances is to dissuade bank managers of the financial reform process. The above preconditions need to from bidding deposit rates recklessly. To do this in China, the govem- be satisfied, and inflation needs to be low and under control. ment may have little option but to place ceilings on deposit rates, Otherwise interest rates could rise to exorbitant heights in real especially since the extent of portfolio losses in banks are not fully terms, threatening the financial viability of borrowers and ultimate- known and the judicial process prevents prompt recovery of loans. ly, that of the financial system itself. This happened in Chile, and to * Bank management should be of high quality. The a lesser extent in Turkey in the early 1 980s. Examples of successful process of interest rate deregulation should take into account the introduction of interest rate deregulation are the Republic of Korea ability of banks to assess and monitor risks, appraise the credit- and Malaysia which adhered most closely to the criteria above. Both worthiness of clients and the financial return on projects, and pre- waited till 1991 to achieve complete interest rate deregulation pare and follow corporate strategies based on a good understand- (although in Malaysia's case, it was for the second time). worth of banks has been restored, intermediation margins steps could be taken quickly (preferably in one year, cer- are acceptable and sustainable, and adequate loan loss pro- tainly in two), eliminating the most grievous distortions in visions protect banks from the possibility of nonrepayment the financial system and, at the same time, sending strong of loans. If deposit rates are liberalized before the financial signals of the government's determination to implement health of banks is secure, there is a high risk that bank financial sector reforms. The remaining steps would then be managers, in an effort to improve profitability, will make introduced only after the government's program of reform risky loans at high interest rates and finance them by bid- in the banking system has made significant progress. ding up deposit rates. This would weaken balance sheets and raise the share of nonperforming assets in the total portfolio. The central bank The objective of liberalizing interest rates in China is desirable and achievable. This should be accomplished Key issue: The central bank's ability to manage monetary through a series of discrete steps, each taken with due aggregates and supervise banks needs strengthening. regard to the progress of reforms in other parts of the finan- Periodic episodes of rapid inflation, including the most cial sector and in the real economy The first four or five recent in 1993 and 1994, provide prima facie evidence of 30 THIE CHINESE ECONOMY: FIGHnNG INFLATON, DEEPENING REFORMS weaknesses in monetary management. At the same time, the Considerable progress has been made on all these government's gradual withdrawal from direct control of fronts. Drafts of twenty-one of thirty new regulations investment decisions underscores the need to develop indi- describing accounting standards have been prepared and rect instruments for achieving this purpose. As noted earlier, distributed for comment. These regulations have been pre- the credit plan, apart from being a key instrument for allo- pared with four criteria in mind: to fulfill specific require- cating resources, is the principal means by which the ments under the Central Bank Law; to ensure internation- People's Bank of China influences aggregate demand and al acceptance of PBC's regulatory and supervisory systems; controls the money supply But it is a relatively inflexible to ensure clarity in the regulations for accurate interpreta- instrument, difficult to adjust in the face of changing macro- tion and effective implementation; and to combine inter- economic circumstances. It is also being eroded as an effec- national best practice with special aspects of China's bank- tive control on total financial sector lending, because banks ing and legal systems. The draft on standards of enterprise are disguising their loans to keep them outside the credit accounts includes definitions of past-due loans, accrual of plan. Each time the authorities issue new regulations to stem interest, loan-loss reserves, off-balance-sheet items, and such unauthorized flows, new channels and techniques are disclosure requirements. The People's Bank of China is created to circumvent them. The year 1995 was no excep- also reviewing the format of reports required of all financial tion; the monetary survey shows that although net domestic institutions and is improving its payments system. credit increased by the amount of the credit plan, total net Supervisory staff are being trained and manuals are being domestic assets increased by half as much again, due to prepared to guide bank examiners on procedures. credit creation outside the credit plan (see chapter 1). Recommendation: Through a painstaking process of insti- The central bank's ability to manage monetary aggre- tution building, improve the central bank's ability to man- gates has been enhanced by the Central Bank Law, which age monetary aggregates and supervise the banking system. forbids lending and overdrafts to the government and cen- The erosion of the credit plan as an effective instrument of tralizes monetary control at the head office of the People's monetary control and shrinking coverage of the credit plan Bank of China (PBC). In addition, the People's Bank of to apply only to policy banks (as proposed in this report) China recalled some loans to financial institutions in 1994, means that the People's Bank of China will need other refined its reserve requirements to suit individual banks' instruments to control monetary aggregates. Certainly, the needs, opened a rediscount window for refinancing strate- People's Bank of China is already in a position to use gic projects, and called for special deposits for the first reserve ratios, asset-liability ratios, and the rediscount facil- time, heralding a more active role in managing the money ity more actively to absorb or inject liquidity into the finan- supply These developments have created the precondi- cial system. Over time, however, additional fine-tuning of tions for the People's Bank of China to move toward open monetary policy will require the use of open market opera- market operations. One step in this direction was the uni- tions to make short-term adjustments to liquidity. fication of the interbank market on January 1, 1996. To prepare for open market operations, the government Others include repurchase arrangements on RMB 20 bil- will need to permit somewhat greater flexibility of interest lion of three-month bills issued to certain domestic banks. rates in the money market and at the shorter end of the These actions are expected to culminate with the initiation maturity spectrum. Without such flexibility, open market of open market operations in April, 1996. operations would be difficult to get off the ground. To ensure that bank managers and central bank supervi- Unification of the interbank market will facilitate this great- sors pay attention to the condition of banks' portfolios, ly The immediate concern in open market operations is the emphasis is being shifted from compliance with key targets withdrawal of liquidity from the financial system, but the and ratios to the observance of prudential norms. This will People's Bank of China has few securitized assets it can sell. require the adoption of modern accounting systems and The issue of RMB 20 billion of the People's Bank of China new financial reporting methods by the banks, the use of a bonds was an initial effort in this direction. The People's uniform risk-based loan portfolio classification system, and Bank of China could also consider securitizing its large accu- a focus in financial accounts on the overall risk borne by mulated stock of loans to the government (RMB 168.77 bil- individual financial institutions. lion at the end of 1994) and selling these on the market FINANCIAI. SECTOR REFORMS: MAJOR ISSUES AND POLICY OPTIONS 31 (with careful consideration of the budgetary consequences they are handicapped by such operational deficiencies as of higher interest payments by government). Another possi- the absence of key management processes, (planning, bility would be to securitize the stock of debt owed by state budgeting, reporting); lack of familiarity with asset and ha- commercial banks to the People's Bank of China. bility management techniques; inadequate accounting Some observers are concerned that interest rate flexibil- standards that render performance and risk assessment ity in the money market could lead to disintermediation of difficult; substandard infrastructure for information sys- the banking system. While this needs to be monitored care- tems; inappropriate internal incentives systems for staff; fully, it is unlikely to become a major problem. In the short and poorly articulated institutional structures and legal term, with greater flexibility in the interest rate structure, frameworks, which are needed to underpin a sound system an auction system could be introduced to sell part of the of corporate governance, eliminate interference and con- annual treasury bond issues, a useful first step toward auc- flicts of interest (especially by local governments), increase tion sales for all treasury securities. Of course, such mea- management autonomy, and protect the interests of own- sures would be more effective in influencing aggregate ers and depositors. demand if enterprises were motivated to keep costs down, These internal weaknesses seem all the more daunting forced to bear their own losses, and no longer given loans considering the challenges that state commercial banks and subsidies to save them from bankruptcy. face. These banks need to change their identity from pas- As efforts are made to use indirect instruments to man- sive financing agents of government-identified projects to age monetary aggregates, the People's Bank of China proactive financial intermediaries serving a creditworthy should take care not to undercut its own efforts by lending client base and ensuring the safe and remunerative use of directly to borrowers or providing high-powered money to depositors' funds. In making this change, state commercial finance policy loans. In fact, the People's Bank of China banks have to deal with excessively decentralized branch should also try to avoid rediscounting policy bonds, systems, high operating costs, an oversized workforce, and because that would implicitly amount to injecting high- staff unfamiliar with modern financial concepts and meth- powered money for their support. In the long run, the ods. Their size alone makes it difficult to implement rela- People's Bank of China should consider removing all poli- tively simple decisions, let alone execute a major change in cy loans from its balance sheet. strategy. Moreover, together with the government, they The central bank's efforts to manage monetary aggre- need to devise and implement a coherent strategy for deal- gates closely will be ineffective if its bank supervisors cannot ing with a relatively high share of nonperforming assets, to ensure that banks follow its prudential and other guidelines introduce adequate loan-loss provisioning, and manage the in spirit and practice. Good supervision will also provide the consequences of these actions on operating margins and added benefit of ensuring safety, soundness, and stability in profitability. At present, these banks have low and declining the banking system. The frequency of on-site inspections capital-asset ratios (see table 3.3), even when assets are not will need to be increased, mostly at provincial, city, and even adjusted for risk; if nonperforming assets are equivalent to county level. Rigorous implementation of accounting and about 20 percent of portfolios, the net worth of these auditing standards needs to be ensured in all banks. And banks is probably negative. training for staff at all levels will be important for achieving Recommendation: Facilitate the transformation of state uniformly high supervision standards. commercial banks into genuine commercial banks. Achieving this objective will require measures by both the State commercial banks government and the banks. Many of the policy measures described earlier will create the framework that will give Key issue: The four state commercial banks face major dif- state commercial banks the appropriate incentives to com- ficulties in their transformation into genuine commercial mercialize their operations. These measures include a financial institutions. State commercial banks are not yet phased reduction in scope and detail of the credit plan and entirely free to lend according to commercial criteria. Like the steady deregulation of interest rates (see above). other state-owned enterprises, they have to shoulder heavy The government could also consider gradually increas- social welfare responsibilities for their staff. In addition, ing the level of competition within the financial sector. The 32 THE CIIINESE ECONOMY: FIGH1TNG INFIAIION, DEEPENING REFORMS state commercial banks should, however, be allowed to ambitious agenda. Multilateral institutions, such as the work through the financial problems they have inherited World Bank and the Asian Development Bank, could also and be given the freedom to choose their clients before be tapped for their finance, expertise, and objectivity. being exposed to full-blown competition from financial institutions that are free of such encumbrances. In the Policy banks short term, therefore, policymakers should focus on preparing clear and consistent criteria for permitting the Key issue: The mandate of policy banks remains unclear, entry of only a limited number of new banks. The numbers especially their relationship with the rest of the financial could be increased in the medium term, once state com- system and their role as instruments of government policy. mercial banks are in a position to compete on an even play- A key issue here is the extent of autonomy to be accorded ing field. At first, only competition from domestically to policy banks. It is not yet clear whether policy banks are owned banks should be allowed, to prepare the founda- to operate as banks, evaluating loans independently, or as tions of a strong banking system. The government could government departments, implementing decisions made by study whether the large size of some of the state commer- the State Planning Commission or the State Economic and cial banks might hinder their development into efficient, Trade Commission. Current procedures suggest an amal- dynamic institutions and explore the advantages and dis- gam of the two. For example, projects that receive an advantages of breaking them up into smaller institutions. endorsement from the State Council under advice from the Only in the longer term, once the banking system is com- State Planning Commission can still be rejected by the petitive and working well under the new set of laws and State Development Bank's loan committee. If the govern- regulations, should policymakers consider opening the ment insists on the project, the State Development Bank banking system fully to foreign competition. notes this for the record. At the same time, the State State commercial banks, for their part, have a formida- Development Bank is under pressure to operate profitably; ble agenda ahead as they transform themselves into com- so, in 1995, it started demanding third-party guarantees for mercial banking institutions. The first item on this agenda loans. Guarantors are usually other enterprises or commer- should be to conduct financial and human resource audits cial banks. Consequently, if any State Development Bank to ascertain their current position and then to prepare loans are not repaid, the commercial banking system will strategic and corporate plans for the future. These plans eventually be expected to meet the cost (either directly or are likely to include the introduction of risk and asset-lia- indirectly), undermining the rationale for creating the poli- bility management techniques; training programs for staff cy banks in the first place. in modern financial and banking techniques (credit and A second issue is the extent to which policy banks are risk evaluation, liquidity management, risk-based provi- expected to take over existing policy loans extended by the sioning); and management information systems to support state commercial banks. While the Agricultural Bank of quick, informed decisionmaking at all levels of manage- China and the Industrial and Commercial Bank of China ment. No single blueprint could cover the different situa- have transferred some policy loans to the Agricultural tions, requirements, and strategic imperatives of each Development Bank of China, the State Development Bank bank. But managers should seek financial expertise from has not accepted any disbursed policy loans from the abroad, especially from Hong Kong, to help implement this People's Construction Bank of China. At the same time, TABLE 3.3 State commercial banks' low and declining capital-asset ratios (in percent) State commercial bank 1989 1990 1991 1992 1993 1994 Industrial and Commercial Bank of China 6.5 5.9 5.7 4.9 4.4 3.3 Agricultural Bank of China 6.3 5.4 4.7 4.0 3.0 3.6 Bank of China 5.4 5.0 4.8 4.5 5.2 4.4 People's Construction Bank of China 7.3 6.2 5.1 4.5 3.3 2.8 Source: Almanac of Chonds F,nonce ond Bonking, 1995. FINANCIAL SECTOR REFORMS: MNJOR ISSUES AND POLICY OPTIONS 33 however, policy banks have taken over disbursements of ment program. In addition, just as in commercial banks, ongoing policy loans from the state commercial banks. policy banks should provision for bad debt and adequately Recommendation: Shape the operations of policy banks account for interest in arrears. to be consistent with financial sector and public finance objectives. The government and the banks' managers each Nonbank financial institutions have their separate roles. For its part, the government needs to issue detailed regulations on how the policy banks will be Key issue: There is a danger that risky financial activity by expected to meet their charters. For example, the State nonbank financial institutions can transmit large systemic Development Bank is restricted to financing projects with shocks to the banking system. Nonbank financial institu- high risk, long gestation, or low financial (but high social) tions include a variety of trust and investment corpora- profitability that would otherwise not be financed through tions, finance companies, leasing companies, insurance the commercial banking system. For this reason, it should companies, and securities dealers (see table 3.1). Many of not be expected to carry the risks associated with financing the trust and investment corporations and most of the projects not of its choosing. Any losses against nonrepay- largest securities dealers were set up as wholly or partially ment of interest or principal should be covered by the bud- owned subsidiaries of the state commercial banks. The get. The State Development Bank's initiative to seek state- rapid growth in the number and size of nonbank financial owned enterprises and commercial banks as guarantors is a institutions is one of the bright spots on the financial land- response to the absence of such a provision and defeats the scape, but it may also harbor considerable risk for the purpose of setting up policy banks in the first place. banking system. Policy banks need to key their bond prices to commer- The absence of laws on nonbank financial institutions cial bank lending rates, to ensure that their cost of funds is and securities markets and weak regulatory oversight have an accurate reflection of the actual cost of borrowing. In meant that the probability of financial failures among large fact, bonds issued by policy banks ( the State Development nonbank financial institutions is high. For example, most Bank in particular) have been administratively placed with trust and investment corporations do not adhere to the commercial banks at interest rates significantly below the provisional regulations issued in 1986, which require them lending rates of commercial banks (for example, 11.2 per- to have capital equivalent to at least 8 percent of their cent for a three-year State Development Bank bond com- assets, to restrict loans to a single enterprise to less than 30 pared to 15.1 percent for a three-year commercial bank percent of the borrower's fixed assets and less than 20 per- loan). This imposes a cost on commercial banks that adds cent of the lender's capital, and to hold fixed assets at less to their already high operating costs. Over the medium than 30 percent of the corporation's capital. The recent term, the placement of policy bank bonds should become example of large losses from manipulative trades in the voluntary. Naturally, total borrowing by policy banks from treasury bond futures market by the Shanghai International the domestic financial market would need to be restricted. Securities Corporation is a cautionary reminder of how One way would be by requiring banks to keep within a suddenly such failures can arise and the disruptions they specified conservative gearing ratio.6 In addition, however, can cause. bank-specific lending ceilings could be set annually for all Even with the imminent severance of ownership links policy banks in line with the monetary program. between banks and nonbank financial institutions, close As is current practice, the composition of policy bank financial connections between these two groups of institu- lending could be agreed between the State Planning tions provide other channels through which losses arising in Commission, the State Economic and Trade Commission, the nonbank financial institutions can be transmitted to the and the policy banks, with ultimate approval from the State banking system, threatening the integrity of the entire Council. Policy banks should have the right to refuse to financial system. Of China's 391 trust and investment cor- finance a project considered technically or financially unvi- porations, 185 are associated with the state commercial able or outside their mandate. Over time, as policy banks banks. After the divestment process, 200 trust and invest- develop their own appraisal capacity, they could assume ment corporations are expected to remain, 20 of them responsibility for evaluating their part of the public invest- national and the remainder provincial institutions. 34 TIE CHINESE ECONOMY: FIGHTING INFLATION, DEEPENING REFORMS Recommendation: Strengthen regulatory oversight of Shanghai and Shenzhen stock exchanges have exhibited nonbank financial institutions and separate their ownership extreme volatility in share prices.7 This tends to be caused from the banking system. To ensure that these institutions by inbuilt problems, such as limited disclosure, the "lottery" follow prudent financial practices in line with international system of assignment, bunching of public offerings, the cir- norms of investor protection and information disclosure, cumscribed role of competitive underwriters or primary the authorities need to draft laws covering the operation dealers, and the limited participation of wholesale and insti- and supervision of nonbank financial institutions, including tutional purchasers of securities such as contractual savings securities markets, finance and leasing firms, housing institutions (e.g. insurance companies) and banks. funds, and mutual funds. Supervision and regulatory Finally, government oversight of the capital market is authority needs to be vested with appropriate agencies. For weak. The regulations are basically sound and in accor- example, the overlapping jurisdiction of the central bank dance with international principles. The weakness comes and China Security Regulatory Commission with respect to from the enforcement of these regulations, which is splin- the licensing and supervision of securities institutions and tered functionally, institutionally, and regionally and divid- mutual funds needs to be rationalized. The laws could also ed between municipal and central authorities. As a result, establish a separate oversight authority for insurance com- some regulations are not overseen by any government insti- panies and pension funds. tution, such as those on corporate bond trading or covering The government is completely severing nonbank finan- securities dealers and institutional participants. cial institutions from banks to protect banks from risks Recommendation: Increase the efficiency, stability, and arising in the nonbank financial sector. With the same transparency of capital markets and reduce systemic risk. objective in mind, and to tighten control over monetary China's capital markets will need to develop in tandem aggregates, the People's Bank of China could also restrict with the financial sector. Only the steady shrinking of the bank lending to nonbank financial institutions through the credit plan will permit the gradual elimination of quotas for interbank market or through other channels. While the share and bond issues. Similarly, greater flexibility in inter- financial failure of a large nonbank financial institution will est rates will facilitate the issuance of government and undoubtedly have repercussions for the banking system, enterprise bonds. In the interim, however, there is much the effects could be dampened by introducing such fire- the authorities can do to build the infrastructure of capital walls between the two sets of institutions. markets. Standards can be set for credit rating agencies, competition can be encouraged among underwriters, and The capital market the regulatory regime and oversight can be strengthened. The stock exchanges, rather than the government, should Key issue: China's capital market suffers from distortions in enforce eligibility criteria for listing companies. Firms listed pricing, access, and market development, while share and on the stock exchange or planning on an initial public bond prices exhibit unusual volatility China's capital mar- offering should be required to disclose more information in ket is subject to the same constraints and controls as the a timely manner. In the bond market, the government rest of the financial sector. The credit plan assigns quotas could announce its borrowing schedule in advance, focus on the amounts of equity and securitized debt that can be on the development of a wholesale bond market, and make issued in any year. The primary market for equities is dis- saving bonds available throughout the year for individual tributed by region, limiting enterprise access to capital mar- and household investors. kets in some regions more than in others. The pattern and To promote the secondary market, the government could speed of capital market development are consequently encourage Shanghai, Shenzhen, and Wuhan to set standards determined by administrative decree rather than market for mutual recognition of each others' bond certificates and forces. These constraints tend to affect primary markets to to examine options for multiple listing. To curb volatility in a greater extent than secondary markets, which seem to be share prices, the government needs to reintroduce daily more sophisticated and to enjoy greater freedoms. price limits immediately . It could subsequently explore the The development of China's capital markets is also possibility over the medium term of introducing a capital inhibited by their volatile and speculative nature. Both the gains tax or a share turnover tax to discourage speculation. FINANCIAL SECTOR REFORMS: MAJOR ISSUES AND POLICY OPTIONS 35 Notes It should be noted that detailed bank-wide portfolio audits have not been conducted for the four state commercial banks. 1. According to government officials, "policy lending" refers to 5. Three-, five-, and eight-year deposits held by households loans for long-gestation, low-profitability, or high-risk projects are offered the greater of the government-set rate of interest considered essential for national economic development. Such (payable on maturity) or the cumulative inflation rate (a weighted projects could be in infrastructure (harbors, airports), energy average of the retail price index, the consumer price index, and (coal, natural gas, electricity), agriculture inputs (fertilizers, grain the producer price index). In July 1995, for example, actual inter- reserves, small scale farming, animal husbandry, water conserva- est rates paid on three- and five-year deposits were 25.25 percent tion, technical innovation), trade (buyers' and suppliers' credits and 27.95 percent respectively; the equivalent interest rates on for exports of capital goods), or the "piLLar industries" (automo- loans of similar maturity were 14.58 and 14.78 percent. biLes, electronics, machinery, construction). 6. The gearing ratio measures the total debt of an entity as a 2. Registered capital is RMB 50 billion for the State ratio of its equity. Thus, if government equity in a policy bank is, Development Bank of China, RMB 20 biLLion for the Agricultural say, RMB 50 billion, and the specified gearing ratio is 4:1, the Development Bank of China, and RMB 2.38 billion for the total outstanding debt of that bank may not exceed RMB 200 Export-Import Bank of China. In addition, the State billion. Development Bank has raised another RMB 126 biLLion (RMB 73 7. The A share market in both Shanghai and Shenzhen has billion in 1994 and RMB 53 billion in 1995) from financial bonds been more volatile than the B share market. placed by the People's Bank of China with the commercial banks. 3. The People's Bank of China retains the authority to impose a binding credit ceiling in the event that the aggregate credit of Reference nationwide commercial banks expands beyond acceptable limits. 4. Statement by Mr. Dai Xiaolong, Governor of the People's King, R. G., and Ross Levine. 1993. "Finance, Entrepreneurship, Bank of China, quoted in the Financial Times, October 24, 1994. and Growth," Journal of Monetary Economics 32: 513-42. 36 THE CHINESE ECONOMY' FIGHTING INFLATION, DEEPENING REFORMS l S | i Chapter 4 Reforming public finances Strong public finances are necessary for sustainable growth imposing heavy costs on banks in the form of bad debts. and stability in a market economy. This is equally important This issue was described in detail in a previous World Bank in China, where the economy is in transition toward a mar- report on China (World Bank 1994). Second, some high ket-based system. Despite recent reforms in public priority government activities have been underfunded, finances, difficulties with tax collection and heavy claims on including health and education services, poverty allevia- government resources (including support for state enter- tion, infrastructure development, and environmental pro- prises) have created inflationary pressures and diverted tection. Moreover, some contingent liabilities associated resources from areas critical to sustaining rapid growth in with market reforms, such as pension payments, unem- the long run. These difficulties, if unresolved, could severe- ployment benefits, redundancy payments, and the moneti- ly weaken the government's ability to provide essential zation of housing benefits may eventually need to be bome public goods and services, and the goal of macroeconomic by the budget. The implications of these expenditure stability over the medium term could become elusive. demands for the government's revenue strategy can be esti- Managing government expenditures will require setting mated only as rough orders of magnitude owing to the priorities and making difficult choices. Not only does the paucity of data on public expenditures in China. (A more government budget need to accommodate costs associated detailed treatment is given in Volume II, Annex 2.) with market reforms, it also needs to play a pivotal role in developing critical social and physical infrastructure to sus- Health and education tain a rapidly growing economy over the medium to long term. Meeting these incremental expenditure needs and China's social indicators are higher than in most low- achieving the government's objective of eliminating the income countries and approach those in middle-income budget deficit by 2000 would mean a major turnaround in countries. The recent declining trend in social sector tax revenue performance. This is a major challenge, requir- spending, however, is eroding China's favorable standing ing actions on a broad front, including improved cost recov- among comparable Asian countries. Public spending on ery for the delivery of public goods and services, better tax education declined from 3.1 percent of GDP in 1985 to 2.4 administration, and some changes in the structure of taxes. percent in 1994. Public health spending shows a similar trend. China spends disproportionately less on basic edu- Expenditure needs TABLE 4.1 The decline in government revenues and the desire to keep Comparing government expenditures the budget deficit in check have led to a steady reduction Central govemment in budgetary expenditures from 33.8 percent of GDP in Govemment expenditures as a expenditures as a percentage of all 1978 to 14.1 percent in 1994. Extrabudgetary government percentage of GNP government expenditures expenditures are estimated to be an additional 3.8 percent Al countries 39.1 72.3 of GDP Industrial countries 47.6 65.9 Today, China's budgetary expenditures as a share of Developing countries 31.7 77.8 GNP are far below those in most other countries (table China (budgetary 1994) 14.1 40.2 Note. Data are fromn a sample of eighteen industrial countries andi twenty-twvo develop- 4.1). Two undesirable outcomes have resulted. First, a sub- ing countries for which data on general government are available in the Intemotiona stantial portion of public expenditures is financed through Finance Stotistics Data are averages over three years ending 1987 or 1988. Source: For country groups, Levin 1991: for China. Ministry of Finance and World Bank the banking system, resulting in inflationary pressures and staff estmates. 37 cation and health care than do other Asian countries. getary allocations, let alone eliminating poverty in the Though China's demographics and one-child policy explain remaining 2,500 counties or addressing the growing prob- some of this low funding, the harsh fact is that education lems of the urban poor. and health are underfunded. Inequalities in education and Extending the multipronged approach adopted in the health care remain large across provinces and between World Bank-financed South-West Poverty Reduction rural and urban areas. Functional illiteracy rates in the far Project to all the poor in China would mean additional west are twice those in the south coast (World Bank 1995).1 public exp'enditures equivalent to 0.33 percent of GDP on Government employees (who live mainly in urban areas) average in the next five years. This is roughly double the spend three times the national average on health care. allocation in the government's National Poverty Reduction Local budgetary health spending per capita in Shanghai is Plan. In addition, the government will need to adjust its twice that in Guandong and seven times that in Anhui. expenditure targeting to assist the urban poor and to reach Generally, provinces with lower incomes per capita and a the poor in counties that have not been designated as poor. higher proportion of minorities tend to have lower public health and education expenditures per capita, higher pri- Environment protection vate costs, and worse social indicators. By increasing budget allocations to basic education and China's increased public spending on pollution control health, the government can arrest a possible deterioration in (from 0.4 percent of GDP in 1980 to 0.67 percent in 1992) China's social indicators, reduce disparities in access to edu- has been inadequate to deal with the environmental conse- cation and health facilities, and promote long-term growth. quences of rapid industrialization. Levels of total suspended To achieve universal access to good quality basic education, particulates remain well above those considered safe by the government expenditures on basic education would need to World Health Organization, sulfur dioxide concentrations rise from the current 1.2 percent of GDP to 2.1 percent by exceed the lowest acceptable Chinese air quality standard, the end of the century Three-quarters of the increase would few urban rivers reach the lowest acceptable Chinese water be devoted to improving quality2 and the remainder to rais- quality standard, groundwater quality continues to fall at an ing the enrollment ratio from 81 to 100 percent. Similarly, alarming rate, and petroleum discharges to surface waters financing a public health package alone would mean an esti- are once again increasing after an initial decline. Nearly 40 mated increase in budgetary expenditures of 0.8 percent of percent of urban China is unserved by sewers, and waste- GDP, or three times current spending according to guide- water is discharged directly into lakes and rivers. Under cur- lines prepared by the World Bank (World Bank 1993). Add rent municipal investment plans, 30 percent of urban China to that 0.6 percent of GDP in increased costs to cover basic will still remain unserved by sewers even in the year 2000. clinical services for China's uninsured rural population,3 Increased public expenditure is only one of several pol- and the incremental costs for adequate provision of health icy tools needed to resolve China's environmental prob- services would be about 1.4 percent of GDP lems. But it is an important one, especially for meeting the investment and operating costs of sewerage facilities, Poverty alleviation wastewater treatment, and solid waste handling.4 Estimates of investments to improve waste treatment and water sup- Despite enormous progress in reducing the number of ply in cities where the need is urgent are on the order of poor since 1978, poverty in rural areas remains widespread RMB 100 billion a year. The budget is expected to finance and living conditions deplorable. There are also signs in some 30 percent of this amount, suggesting budgetary recent years of a new urban underclass, a consequence of expenditure requirements of about 0.2 percent of GDP per increased urban unemployment, lower real incomes of year over currently budgeted levels. fixed-income pensioners, and rural-urban migration. The government has been targeting the rural poor through the Infrastructure National Poverty Reduction (8-7) Plan with some success. But eliminating poverty in the designated 592 poor coun- China has made huge strides in infrastructure investments ties by 2000 will be difficult to achieve with existing bud- over the last decade, but still needs greater public spending 38 THE CHINESE ECONOMY: FIGHTNG INFLATION, DEEPENING REFORMS in this area. Investments amounted to 7.5 percent of GDP percent payroll tax, sale of state enterprise assets, and in 1994, up from 4.4 percent in 1985. Higher tariffs (for incremental budgetary contributions amounting to about example, on power) and directed credit through the bank- 0.7 percent of GDP (table 4.2; World Bank 1996). To this ing system have been the principal sources of finance. But must be added projected unemployment benefits of about infrastructure needs in China are huge. Although the pri- 0.2 percent of GDP that will also need to be met from the vate sector is expected to play a key role in meeting these budget. This assumes a 5 percent urban unemployment needs, public spending on infrastructure will also have to rate and benefit levels equivalent to the public pillar of the. rise significantly. This is especially so in interior provinces. pension scheme. So far, though, budgetary contributions have been small. As noted, these estimates of additional public expendi- Of particular concern is China's road infrastructure, ture requirements in priority areas represent only rough especially in rural areas and in interior provinces, where orders of magnitude. Together, they add up to 4.6 percent cost recovery is not a viable option. Physical indicators of GDP (table 4.3), and would raise total government show that China compares unfavorably with other large expenditures to about 22.5 percent of GDP, bringing them countries in per capita coverage of the road network. It is, more in line with government expenditures in other coun- therefore, reasonable for China to invest about 8-9 percent tries.5 This is a conservative estimate, however. It does not of GDP into infrastructure each year and to increase bud- include the growing cost of government services (whose getary allocations by about 0.7-1.3 percent of GDP relative costs will rise with economic growth and wages), the monetization of other in-kind benefits to civil servants Social insurance (notably housing), or the possible need for a financial bailout of the state commercial banks (see chapter 3) It is important to evaluate carefully (and plan for) the bud- among others. getary implications of alternative options being considered Financing these expenditures will require additional for pension reform. Take one such option-the multipillar government revenues equivalent to about 6.0 percent of approach-currently favored by the government. The first GDP. This points to the fundamental importance of stop- of these pillars would have welfare and redistributive objec- ping the decline in revenues (as a share of GDP), and tives and be funded on a pay-as-you-go basis. The second reversing the trend quickly Successful implementation of would involve fully funded, mandated, individual retire- the government's tax reforms is thus central to ensuring the ment accounts. The third would be voluntary savings. An sustainability of rapid growth with stability. ongoing study by the World Bank on pension reform in China recommends a viable pension scheme funded by a 6 TABLE 4.3 TABLE 4.2 Simulation of proposed expenditures and financing, Budgetary impact of pension reform: simulating 1994 pension liabilities in 1994 Proposed expenditure Percentage of GDP Amount Percentage Total proposed expenditures 22.5 (billion RMB) of GDP Actual budgetary expenditures, 1994 14.1 Extrabudgetary expenditures' 3.8 Actual expenditures' 86.2 1.9 Additional proposed expenditures 4.6 Proposed scheme' 78.8 1.7 Education (0.9) First pillar 31.9 0.7 Health (1.4) Second pillar 46.9 1.0 Poverty alleviation (0.2) Environment (0.2) Resources already in budget Infrastructure (1.0) for pension payments 29.6 0.6 Social Insurance (0.9) Financing gap' 49.2 1.1 Financed by 22.5 Budget 29.7 0.7 Budgetary revenues 12.4 Sale of assets 19.5 0.4 Extrabudgetary revenues 4.1 a. Pension expenditures of state-owned units. Additional revenue required 6.0 b. Benefit level reduced to 60 percent of wages. c. Proposed scheme less resources already in budget. a. Based on 1 993 figures. Source: World Bank staff estimates. Source World Bank staff estimates. REFORMING PUBLIC FINANCES 39 Mobilizing revenues individual income tax amounted to less than 0.2 percent of GDP The tax authorities estimate that this is about half of Raising government revenues as a share of GDP will what should be collected. The current exemption level of Y require a combination of growth, a broader tax base, and 800 per month is much higher than the minimum for living improved compliance through better tax administration. In expenditures that is usually exempted in other countries, the short run, improving compliance is likely to contribute and keeps most individuals outside the tax net. But as the most, while phasing out the plethora of tax exemptions wages are increasingly market-determined and the subsi- for domestic and foreign firms would greatly improve the dies that wage earners now obtain in the form of housing, buoyancy of the tax system. In the longer run, further tax education, and health care are monetized, it is likely that a reforms may be needed to increase tax revenues as a share larger share of value added will accrue to labor. Simply of GDP Several options are available to the government in keeping the exemption level constant in nominal terms (as both the short and the long term: was done in 1995) would bring an increasing number of * Improve the coverage and compliance of the value added people into the tax net, and allow revenues to increase tax. As noted earlier (see chapter 1), almost half of all tax gradually. llustrative simulations on the basis of urban revenues in China come from the value added tax. But household surveys indicate that with a broader tax base potential revenues from the value added tax are even larg- and better compliance, revenues from the individual tax er. At about 70 percent, compliance in China is compara- would rise by about 0.8 percent of GDP (see Annex 2 in ble to that in other developing countries with similar tax Volume Ui).8 To achieve this target, however, the tax bases, but falls short of the 90-95 percent compliance rates authorities would have to process 160 million taxpayers, achieved by top tax performers.6 Increasing compliance to compared to the current 30 million. 85 percent, a feasible target in light of the ongoing tax - Merge the foreign and domestic enterprise income tax administration reforms, would yield incremental revenues rates. This option is already under active consideration by slightly over 1 percent of GDP Each additional percentage the government. Foreign-funded enterprises enjoy lower improvement in compliance would yield a further 0.07 per- income tax rates and a variety of other tax and tariff cent of GDP Extending the VAT to services, which is desir- exemptions. Favorable treatment may have been justified able for efficiency reasons, would increase the VAT tax base in the past, on grounds that foreign enterprises bring new by about 8.6 percent of GDP but would not necessarily technologies, management techniques, and marketing generate additional revenues since the sector is now subject savvy that result in spillover benefits for Chinese firms. to the separate business tax.7 But increasingly foreigners are investing in China because - Increase application of the individual income tax. China's of the attractive domestic market. Moreover, much of tax structure relies too heavily on the VAT. Other countries China's subsidy to foreign enterprises is taxed in the have more diversified tax bases, with income taxes playing home country of the investor and thus probably has little a much larger role (table 4.4). China's revenues from the effect on the decision to invest in China. Finally, tax TABLE 4.4 Comparisons of the composition of government tax revenue (percentage of total tax revenues) Personal Social Corporate VAT/general Excise Trade Wealth and Other income tax security tax income tax sales taxes taxes taxes property taxes taxes Industrial countres 28 28 8 16 10 3 3 4 Developing countries I 1 6 18 14 13 29 3 6 Asia 15 0 17 16 16 31 1 4 Europe 15 18 7 21 9 17 2 11 Westem hemisphere 8 12 14 14 18 21 3 10 China (1994) 1.5 n.a. 14 46 1 1 6 - 8 n.a. is not applicable; - is not available. Note: For countres other than China, revenues refer to central government; for China to general government. Source: Burgess and Stern 1993; IMF 40 THE CHINESE ECONOMY: FIGHTING INFLATION, DEEPENING REFORMS advantages for foreign enterprises tends to encourage assessment, development of efficient audit selection and roundtripping (see chapter 1), thus reducing the tax base procedures, introduction of best-practice computerized of domestic enterprises. information systems, internal reorganization of tax admin- Applying the domestic enterprise income tax rate to for- istration units and improved incentives for tax administra- eign-funded enterprises would not yield substantial addi- tors, close cooperation between the national and local tax tional revenues in the short term because the tax base of services, improvement in presumptive taxation methods, foreign enterprises is small.9 Their current low profits can and implementation of a streamlined system of stiff, but in part be explained by the long gestation period of their fair, monetary fines for various tax offenses. investments. Using assumptions about the average gesta- Together, then, these tax and tax administration mea- tion period of investments and the rate of return, we esti- sures could potentially raise incremental revenues equiva- mate that the government could raise 1.2 percent of GDP lent to 6.0 percent of GDP (table 4.5). Achieving that tar- in incremental tax revenues from this source by the end of get would require a monumental effort from the Chinese the century.'0 tax authorities. Just stabilizing the declining trend in the * Increase taxes on pollutants. Environmental levies and tax revenues as a share of GDP is proving difficult charges alone may not affect behavior enough to ade- enough. The difficulties associated with reversing this quately protect the environment. Taxing pollutants is an trend cannot be underestimated. Nevertheless, the important complementary option. The concentrated distri- options outlined above (and presented in greater detail in bution of the main pollutants (coal, petroleum) makes such Annex 2 in Volume II) put forward realistic targets, pro- products easy to tax. Moreover, the sheer quantities of pol- vided the authorities at the highest level are committed to lutants used in China makes taxing them an attractive achieving them. proposition. To illustrate, in 1994 China used 209 million tons of oil products, including crude oil. Taxing all oil prod- Intergovernmental resource transfers ucts at RMB 1 per liter would have generated about RMB 133 billion, or almost 3 percent of GDP in revenues. Marrying the objective of revenue mobilization to the pub- Taxing only non-industrial use would have still yielded lic expenditure needs of the economy (discussed earlier) incremental revenues of almost RMB 50 billion. will require an effective system of intergovernmental - Introduce social security taxes. As noted earlier, some grants for redistributing the revenue surplus from the cen- form of social security tax will become necessary to finance tral government to the provinces. The revenue assign- the basic pension pillar for (urban) workers. A pay-as-you- ments introduced in 1994 are expected to gradually raise go basic pension provision does not really necessitate a sep- the central government's share in total revenues to 60 per- arate tax. But experience in other countries shows less cent. The government is considering various options for resistance to a payroll tax for a generally accepted purpose redistributing the surplus revenues of the central govern- such as pensions than to raising general taxes. Moreover, ment. One overarching objective will need to be redistrib- enforcement becomes easier when pension eligibility is ution in favor of poorer provinces and counties. Both rich linked to paid-in premiums, since the payer has an incen- TABLE 4.5 tive to make regular payments. Another attractive feature Incremental revenues by 2000 from recommended of payroll taxes is its administrative similarity to the widely tax measures applied personal income tax withholding. As discussed (percentage of GDP) above, a payroll tax of 6 percent (leading to incremental Measure Revenue effect by 2000 revenues equivalent to 0.9 percent of GDP) could cover I.1 public pension liabilities and provide for unemployment Individual income tax 0.8 insurance. Enterprise income tax 1.2 * Improve tax administration. We conservatively estimate Taxes on pollutants 0 .0 that ongoing and further reforms to the tax administration Improved tax administration 1.0 system could raise revenues by 0.8-1.0 percent of GDP Total 6.0 These measures include a move toward taxpayer self- Source World Bank staff estimnates. REFORMING PUBLIC FINANCES 41 and poor provinces have an inherent interest in such a Notes scheme. Poor provinces and counties would obviously wel- come net resource transfers from the center to supplement 1. The far west includes Xinjiang, Xizang, Qinghai, Gansu, and thei indequte isca reourcs. iche prvincs wuld Ningxia. The south coast includes Guangdong and Fujian. their indeuaeicarsorcsRchrroicewii2. Public expenditure per capita in Liaoning province was also find such a scheme beneficial. It would lower pres- chosen as the benchmark, because it is the non-city province with sures for migration from poor to rich provinces, reduce the highest such expenditures after Tibet. tensions by lowering disparities in income per capita and 3. This is smaller than the 0.6 percent of GDP that could be in poverty across provinces, and add infrastructure to poor saved if government and state enterprise employees reduced their provinces that would help open markets in the interior and average spending on health from three to two times the national integrate poorer provinces more fully with the national average. 4. Other, perhaps more important, policy tools would include economy. regulatory control and appropriate pricing. An effective intergovernmental grants scheme would 5. This assumes that the current level of budgetary subsidies require mechanisms to ensure that central resources find (2-3 percent of GDP) would be maintained and reoriented their way to poor counties and to the subprovincial levels. toward explicit budgetary support in the form of investment and One way would be to earmark central resources for poor working capital for industrial policy and social objectives. counties, relyin initially onincomepercapitadat. As6. The estimate for China's compliance was provided by the counties, relying initially on income per capitadata,Asmall State Tax Administration and was based on the 1992 input-output program of this sort exists already, but it needs to be tables. expanded considerably to reach China's 70 million poor. 7. Consumption of services added up to 19.2 percent of GDP Care would also need to be taken to ensure that such trans- in 1990. However, the net addition to the VAT tax base would be fers represent additional funding and that subprovincial fis less, since industry had inputs to the services sector of about 10.6 cal arrangements demonstrate a redistributive bias in their percent of GDP2 expenditureallocation across counties. 8. The simulations are illustrative. The household surveys as expnditummarre forming public finances in China will be published in the China Statistical Yearbook provide far too little In summary, reforming public finances in China will be detail to estimate detailed projections for the individual income tax. pivotal for sustaining development. Transition to a social- 9. The vast majority of foreign-funded enterprises are in the ist market economy involves more than market reforms. It industrial sector. has far-reaching implications for public finances and the 10. Assuming a gestation period of four years, the stock of role of government. This chapter identified areas where foreign investment yielding profits by the end of the century additional budgetary expenditures would be desirable, would be as high as US$152 billion, or about 17 percent of GDP partly to facilitate reforms in key areas of the economy, but also to improve the quality, and so the sustainability, of References growth. It also showed that meeting these expenditure needs through revenue mobilization is feasible with Burgess, R. and N. Stem. 1993. "Taxation and Development," improvements in tax administration and a broadening of Journal of Economic Literature 31: 762-830. the tax base. These measures will need to be complement- Levin, J. 1991. "Measuring the Role of Subnational e i v u r c s t u Governments." IMF Working Papers 91-8, Washington, D.C. ed by improved budgetary processes and the introduction World Bank. 1996. "China: Pension Systems Reform." Report of mechanisms to redistribute surplus central revenues to No. 15121-CHA, China and Mongolia Department, World poor provinces and counties. Bank, Washington, D.C. 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