China - Finance and investment

Report No. 6445-CHA China finance and Investment June 11, 1987 Asia Regional Office FOR OFFICIAL USE ONLY .:~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~-: ' U~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~Z C~~~~~~~~~~ Docmnent of the World Bank This document has a restricted distribution and may be used by recipients orly in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. )~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~6  CURRENCY EQUIVALENTS The Chinese currency is called Renminibi (RMB). It is denominated in Yuan (Y). Each Yuan is I Yuan = 10 jiao = 100 fen Calendar 1985 December 1986 US$1.00 = Y 2.94 US$1.00 = Y 3.70 Y 1.00 = US$0.34 Y 1.00 US$0.27 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System LIST OF ACRONYMS ABC - Agricultural Bank of China BOC - Bank of China CIB - China Investment Bank CICT - Consolidated industrial and commercial tax CITIC - China International Trust and Investment Company GDP - Gross domestic product GNP - Gross national product GVIO - Gross value of industrial output IBRD - International Bank for Rec.rstruction and Development (World Bank) ICBC - Industrial and Commercial Bank of China ICIT - Industrial and commercial tax IMF - International Monetary Fund ITC - Investment and Trust Company MOF - Ministry of Finance PBC - People's Bank of China PCBC - People's Construction Bank of China PICC - People's Insurance Company of China .ACC - Rural credit cooperative SEC - State Economic Commission SEZ - Special Economic Zone SNA - U.N. System of National Accounts SPc - State Planning Commission IA1 'a1ue-aaded tax  FOR OFFICiaL UE ONLY Preface As a central element of its overall strategy to improve allocative efficiency and promote the modernization and growth of the economy, the Chinese Government set in motion in 1979 a series of economic reform measures aimed at decentralizing production and investment decisions and subjecting them increasingly to market. influences. This report discusses the progress of the reform Lnd its impacts thus far on the procestles and institutions of savings mobilization, financial intermediation and investment. It attempts to clarify the issue6 and interrelationships of the various reform measures that may be needed to achieve the reform's objectives. This report and its annexes are based on the findings of a mission that visited China during February/March 1986. In addition to interviews and discussions in Beijing, the mission visited the capital cities and nearby rural countries of three provincess Shanghai Muni-ipality, Hubei, and Giangdong. The misoion consisted of Fred Levy (Mission chief) Gerhard Pohl (Team leader, financial sector) William Byrd (Team leader, government and enterpri_a sectors) Jane Armitage (Household finance) Rudolf van der Bijl (Securities markets and nonbank financial intermediaries) Ramesh Deshpande (Rural finance) Hans Horch, coneul.tant (Banking system) Madhusudan Joshi (Government planning) Diane McNaughton (Bank management) J.D. Von Pischke (Enterprise finance) Kunio Saito, IMF (Financial system) Christine Wallich (Tax system, social security) The mission was also accompanied in the field and has received substantive inputs fr"mn Messrs. Millard Long and Antoine van Agtmael. The mission was conducted in collaboration with a Chinese counterpart team consisting of representative.. from the State Planning Commission, the Ministry of Finance, the Economic System Reform Commission, and the People's Bank of China. Members of the counterpart team were Messrs. Lin Fatang, Wang Changlin, Chen Yiqi, and Zhang Zhiqiang (SPC); Messrs. Gao Jian and Sheng Fulai (MOP); Mr. Xia Bin and Ms. Duan Shu (PBC); and Mme. Xu Meizheng (SIC). This document has a rtricted distribution anJ msy be used by recipients only in the performance of their officW duties. Its contents may not otherwise be disclosed without World Bank authofization.  CHINA FINANCE AND INVESTMENT Table of Contents Page No. Preface A. The Progress of Reforms: 1979-1986......................... 1 B. Recent Changes in Saving and Investment PEtterns In China... 3 C. The Interrelatedness of Reform Measures..................... 8 D. Organization of the Report........... e............*....... 10 PART ONE - ENTERPRISE 7INANCE AND INVESTMENT......................... 11 Resource Allocation in the Competitive Market................... 11 Outline of Chapters II-IV....................... 13 II. ENTERPRISE .EVIRO4E.T .......... .,.. 15 A. Introduction .................... .... ......e.... 15 B. The Changing Enterprise Environment......................... 16 II. ENTERPRISE OWNERSHIP, CONTROL, AND NANAGEIENT ............... ** 22 A. The Nature of Enterprise Ouncrship.......................... 23 B. The Separation of Ownership and Management .................. 25 C. The Ownership of State Enterprises in China................. 26 D. Control and Management of State Enterprises........4........ 30 IV, ENTERPRISE FINANCIAL ISSUES ..................... .......... 33 A. Financial Management ... .....e............e.e.e e 33 B. The Treatment of Unsuccessful Enterprises................... 37 C. The Financing of Social Security and Worker Housing......... 38 PART TWO - THE FINANCIAL SYSTEM ......................................0 42 The Role of the Financial Syutem................................ 42 The Efficiency of Financial Intermediation............e ......... 44  - ii - Page No. V. THE BANKING SYSTEM......................*......................... 47 A. Introductiono.......................... * ** ...............ooo o 47 B. Banking Structure and Ownership.e........................... 55 C. The Future Role of the People's Construction Bank******k**** 57 D. Interest Rates ...... 58 E. Bank Management and Staffingea f f i ng......................... 60 VI. REGULATION OF THE BANKING SYSTEM,SE.... 61 A. Monetary Policy..... ,..................................... 61 B. Prudential Regulation and Supervision....................... 63 VII. OTHER FINANCIAL INSTITUTIONS..I... 66 A. Nonbank Financial Institutionsatituti.........o ns........... 66 B. Financial M 69 PART THREE - C0VERNMENT INVESTMENT AND FINANCE.............A 75 Centralization vs. Decentralization in Investment Decisions*.... 75 VIII. GOVERNMENT INVESTMENT DECISIONS*............................ ... 82 A. Investment Pl a n n i n g 82 B. Project Planning... 87 C. Summary: Investment Planning and Economic Reform****#**.*,, 89 IX. GOVERNMENT REVENUESV............ENU...,.......ES..........o..... 90 A. Introduction........ .... . .................... ............... 90 B. The Need to Widen the Tax Bsse 91 C. The Need for Greater Tax Neutrality....... 93 D. The Reform of Tax Administration............................ 95 E* User Chage.. 96 F. Debt Fin..c i n g ............... . ... 98 X. THE SEQUENCING OF REFORMS ..... ................. o .................. 101 A. Introductiono........................ .o.............. ......... 101 B Fundamental Preconditions for Efficient Decentralization ... 101 C. Enterprise Reforms....................... ................... 106 D. Financial System Reforms ........ .................. ....... .. . 108 E. Government Investment and Finance........................... 113  SUMMARY AND CONCLUSIONS I. Introductin i. As a central element of its overall strategy to improve allocative efficiency and promote the modernization and growth of the economy, the Chinese Government set in motion in 1979 a process of reform aimed at decentralizing production and investment decisions and subjecting them increasingly to market influences. This report and its annexes attempt to clarify the issues and interrelationships of the various policy reforms and, in light of international experience, identify further measures that may be needed to assure the adequacy of 8avings mobilization and the intended impact of the reform on the efficiency of investment. Progress of the Reforms: 1979-1986 ii. Although no clear and well-defined blueprint for reform is possible, several directions have emerged from the authorities' analyses of the causes of inefficiency in the prereform economic system. Specifically, the reforms are moving the economy toward greater decentralization of microeconomic decision-making; increased reliance on markets, material incentives, and indirect economic "levers" to motivate efficient economic decisions; and opening the economy to foreign trade, investment, and technology. iii. Reform measures were first introduced and have progressed the farthest in the rural areas, where the combination of price reform and the adoption of individual producer responsibility has resulted both in a large increase in output and a shift of land use to higher-value uses. Rising agricultural productivity has been accompanied by a rapid growth of rural indus;try as well as of transport, commerce, and other service activities. iv. Price reforms in the urban economy have followed a similar approach to that in the rural sector, and state enterprise managers have been given greater authority over production and marketing decisions. Important changes have also occurred in the way state enterprise investments are determined and financed. The former system of profit remittance to the state budget has been replaced by a tax system that permits enterprises to retain and enjoy some discretionary control over a significant share of their profits. Moreover, although state-owned enterprises will continue to account for the major share of industrial output and investment, an important element of the reform process in both the urban and rural sectors has been the proliferation a d rapid growth of nonstate forms of enterprise ownership and management. v. Significant changes have also begun in the financial sector. The ordinary banking activities of the People's Bank of China (PBC) have been separated from its central banking responsibilities and assigned to newly created specialized banking institutions. Moreover, monetary control is increasingly to depend on indirect policy instruments in place of direct credit controls. The interest rate has been raised significantly and is to become an important means of limiting the demand for credit as well as an incentive for both increased financial savings and their use in more productive investments. A large number of new, nonbank financial institutions have been established, and a variety of new financial instruments are contributing to the growth of an incipient financial market.  -ii. vi. Nevertheless, the urban enterprise and financial system reforms are far from complete. Significant price distortions remain; managerial decisions are still strongly influenced by government intervention; and competition is still largely absent in the state sector. Enterprise losses continue to be subsidized by central or local governmsnt budgets, so that neither borrowing enterprises nor their lenders perceive any real risk in their transactions. An excessive demand for credit continues to be encouraged also by low interest rates on loans for capital construction investment, heavy subsidization of debt by the tax system, and by the low interest rates allowed to enterprises on financial assets. At the same time, managerial incentives to improve productivity are weakened by frequently arbitrary tax treatment and the continued remittance of financial sector profits to the budget. Recent Changes in Savings and Investment Patterns in China vii. Savings and investment, as a fraction of GDP, dipped in the early years of economic reform but rose rapidly after 1981 to again exceed 30% of GDP. Until 1985, China was transferring savings abroad and accumulating international reserves. Rapid investment growth in 1985 and 1986, however, resulted in China becoming a net importer of capital. viii. More dramatic has been the shift in the sources of domestic savings. Consistent with the intent of the economic reform, the share of total savings generated by the state budget declined from 51% in 1978 to 23% in 1985. At the same time, the shAre of household savings rose from less than 15% to almost 46%. The combined savings of enterprises and local governments jumped from 34% to 57% of total savings between 1978 and 1982, as the combined result of profit retention and the decentralization of the tax base, but then fell back to 32% by 1985 as a consequence of new taxes and increased wage and worker welfare expenditures. ix. A parallel trend in the decentralization of investment decisions is reflected in a number of indicators, including the relatively rapid growth of output of enterprises under nonstdte forms of ownership; the decline in the share of capital construction (which tends to be the most closely controlled) in total investment; and the sharp decrease in the proportion of state enterprise fixed investment financed by the budget (from more than 60% in 1978 to 26% in 1985). The Interrelatedness of Reform Measures x. In assessing the current state of reform and contemplating its next steps, it is important to recognize the essential interrelationships among the various reform measures. Each decision has implications for other decisions that must be taken into account if the entire confluence of decisions is to have the intended results. xi. By the late 1970s, the Chinese authorities had concluded that improved economic efficiency and sustained growth required the decentralization of most production decisions to the line managers of the production units. But, decentralization alone does not assure efficient production decisions. Also needed are a competitive environment; the creation of a direct link between the economic results of an enterprise and the material rewards or its owners, managers, and workers; establishment of each enterprise as a separate accounting entity, responsible for its own profits and losses; and prices that correctly reflect the relative  -iii- scarcities and productivities of resources. Recognition of these conditions has shaped important elements of the reform, including the substitution of profits taxation for profit remittance, adoption of the principle of "pay according to work", the withdrawal of unlimited government support for unprofitable enterprises and introduction of a bankruptcy law, substantial price corrections and reduction of the proportion of goods subject to administered prices, and the opening of the economy to foreign trade. xii. Establishment of the conditions for efficient, decentralized investment decisions is somewhat more complicated than for production decisions because of the long-term nature of the former's uonsequences and the likelihood that those consequences may lie beyond the time horizon of the decision-makers responsible. Even the interest of owners in the long- term profitability and viability of an enterprise may be tenuous, depending on the definition of ownership rights and obligations and the existence of mechanisms through which owners can realize the value of their asset holdings. Thus, it may be necessary to clarify the locus and nature of socialist ownership in China, if enterprise investments are to achieve their desired efficiency. xiii. The decentralization of the responsibility for savings and for investment decision-making makes the creation of an efficient system of financial intermediation crucial to the economic reform. The requirements for an efficient financial system are not very different from those of efficient production institutions. Competition, responsibility for profits and losses, incentives to good performance, and rational pricing--in this case, the interest rate--are basic elements of efficient decentralized decisions. xiv. The decisions on enterprise reform and financial sector reform have, in turn, major implications for the role of government in economic management. The reduced involvement of government in the microeconomic decisions of enterprises is accompanied by an increased burden for regulating and guiding the macroeconomy. While decentralization can lead to more efficient resource use, it also complicates the task of managing aggregate demand and requires the development of quite different policy touls, better and more timely information flows to the policy-makers, and new techniques of analysis and policy planning. OQrganization of the Report xv. The report is organized in three parts dealing, respectively, with issues of enterprise finance and irvestment, the development of the financial sector, and government finance and investment. Each part is preceded by a short note explaining some of the concepts employed. A final chapter summarizes the report's recommendations and comments on the sequencing of the various reform elements. (The technical notes and concluding chapter are not summarized here.) II. Enterorise Environgment Introduction xvi. The Chinese economy consists of a very large number of mostly small enterprises, and the number has been growing very rapidly since the beginning of the economic reform. Only a small fraction (4%) of industrial  - iv- enterprises is organized under state ownership, and the number of enterprises under nonstate forms of ownership (collectives and individually owned enterprises) is growing much more rapidly. State-owned enterprises account for 70% of industrial output, however, and will continue to be the predominant mode in terms of output and investment. xvii. In the prereform period, most production and investment decisions were made by government administrators, outside the enterprises themselves. There was no sustained link between enterprise efficiency and the benefits or losses accruing either to the persons directing or responsible for maintaining the enterprise. Profits were remitted to the state, and the financing of both investment and current costs was provided by the state. Enterprises and their government sponsors were judged largely on the physical volumes of output they produced; a principal interest was thus in more investment, whether profitable or not. xviii. Since 1979, the scope of the mandatory allocation system has been substantially narrowed, and a significant proportion of goods and services are now sold through markets. Profit remittances have been replaced by a tax system that permits state enterprises to retain earnings, and enterprise managers have been given gr,ater authority to determine the use of those earnings. Managers also have greater responsibility for day-to- day decisions regarding the volume, composition, and pricing of output; the source of inputs; marketing; the distribution of rewards among employees; etc. Nevertheless, the reform has been only partially implemented, and many problems remain. Pric Refor xix. While prices in a centrally controlled economy may not play a significant role in resource allocation, the rationality of decentralized production and investment decisions depends crucially on the price signals to which those decisions respond. Substantial progress has been made over the past several years in freeing some prices to be determined principally by supply and demand, and in the adjustment of those prices that continue to be administered. Some serious distortions remain, however, with particular importance for investment decisions. Given the long-lasting consequences of investment decisions, the longer price reform is delayed, the greater are the likely costs of eventual adjustment. xx. The need for further price reform is widely recognized in China, but there is concern that necessary adjustments could cause serious dislocations and set into motion a spiral of cost-push inflation that the monetary authorities might be unable to control. Although the analysis of price reform is beyond the scope of this report, there is some reason to believe that the magnitude of distortions resulting from China's cost-plus price setting, and the likely disruption caused by adjustment, may be less than is commonly believed. Moreover, the inflationary impact of price reform can be limited, if appropriate monetary and fiscal constraint are imposed. ComDetitio xxi. An enterprise with decentralized decision-making authority and monopoly power, whether state-owned or privately owned, feels little compulsion to seek ways to improve its product, reduce its costs, and better satisfy its customers. In contrast, an independent enterprise  -V. subject to competition is compelled to operate efficiently and at least keep pace with the innovations of its competitors, becAuse not to do so would result in the 1088 of customers and the eventual failure of the enterprise. xxii. The expansion of the nonstate sector in China, the granting of greater discretionary authority to state enterprise managers, and the opening to foreign trade have begun to introduce some competition into the urban economy, but in many sectors competition remains severely limited by the protectionist tendencies of line ministries and local governments. For a competitive environment to be created and sustained, international experience suggests the desirability of establishing a central government agency with the responsibility and authority for monitoring competition in the economy and enforcing legal prohibitions against anticompetitive behaviors. Although it would take time for such an agency to be established and become fully functional, work could begin now to formulate the necessary laws and regulations and to train the necessary staff. Resgonsibility fox Profits and Losses xxiii. China's state-owned enterprises are still not truly responsible for their profits and losses. The expectation continues that government will subsidize losses. Profits taxation has replaced remittances, but taxes are typically negotiated on an ad hoc;, enterprise-by-enterprise basis. Taxes may even be forgiven, if necessary, to allow an enterprise to repay debt, and the debt itself may be forgiven or indefinitely postponed. This variation in tax treatment and the responsibility for enterprise debts seriously weakens incentives for efficient production and investment. xxiv. The clear establishment of enterprise responsibility for profits and losses will, among other things, require the formulation of clear accounting rules, evenhanded application of tax laws, and a well defined framework of law governing business relationships among enterprises, including financial institutions, and betwewn enterprises and final consumers. Clear rules and procedures are also needed for the reorganization or liquidation of failed enterprises and the adjudication of the claims of their creditors. Aggrsgate Demand Management xxv. The decentralization of decision-making authority and financial resources to independent enterprises implies a loss of direct governmental control over aggregate demand. In the absence of adequate tools of indirect macroeconomic management, this loss of control would constitute a threat to economic stability and the success of the eot.cnomic reform. Fear that the government could lose control of aggregate demand is, as noted above, one of the major factors inhibiting needed price reform. xxvi. A number of distortions in the present incentive system contribute to excessive investment and consumption demand. The deduction of debt repayments from before-tax profits and the frequent deferral or forgiveness of taxes to permit debt repayment encourage borrowing and free enterprises' own funds for wage bonuses and worker welfare expenditures. The absence of risk of loan default and enterprise failure removes the restraint of debt- servicing capacity and creditworthiness from the decisions of both borrowers and creditors. Both investment and consumption demand are also stimulated by the low interest rates charged on capital construction loans  -vi- and by restrictions on the returns enterprises can earn on holdings of financial assets. Modification of these incentives would not require major institutional changes and could be introduced relatively quickly. xxvi. The People's Bank's ability to resist credit demands is also weakened by the heavy political pressures placed on it by government agencies, particularly at the local branch levels, and by a general perception that the banking system should automatically meet all working capital demand. The PBC's authority over credit expansion needs to be strengthened (see para. lxvii). It will also need better and more timely informatior. flows on which to base its policy decisions and a larger trained staff of researchers and policy analysts. Factor MobiliSy xxviii. Restrictions on the mobility of any factor of production limit the efficiency with which all factors can be used. Restrictions on labor mobility, for example, can reduce or eliminate the profitability of investments that reduce the costs of production and aluo restrict the access of new and growing enterprises to skilled, experienced workers. Similarly, restrictions on the transfer of land-use rights among enterprises limit their flexibility to adopt new technology and adapt to changing cost p&tterns--e.g. from growing traffic congestion. Such constraints are particularly costly when major changes in industrial structure and technology are needed. xxix. One factor reducing labor mobility in ChirA is the current heavy dependence of workers on their enterprises, engendered by the latters' unfunded responsibility for pensions, housing, and other elements of the "social safety net". Needed, among other things, are the establishment of national or provincial pension systems that protect a worker's retirement benefits when he changes jobs; the creation of a government-sponsored program of job retraining, placement, and unemployment insurance; and the development of housing finance institutions. III. Enterprise Ownershig. Control. and Management xxX. The frequently shifting designation of responsibility' for specific enterprises among government agencies and levels of government, and the changing nature of that responsibility being shaped by the economic reform, have left state enterprise ownership vaguely defined. At the same time, state enterprise managers are to be given greater responsibility, but the specific division of authority betwjen them and the government organizations designated to oversee them remains undefined. These are among the most difficult issues of the reform process. The Nature of EnterRrise Ownershig xxxi. Although it is intended that day-to-day production decisionT3 should be decentralized to enterprise managers, some ambivalence remains regarding the decentralization of investment decisions. Part of this ambivalence derives from the nature of investment decisions. It also reflects concerns that decentralization has already resulted in too large a share of retained earnings being diverted to bonuses and welfare expenditures, excossive aggregate demand, and the financing of low-return investments, at the same time that there is a shortage of funds for high- priority investments under the state plan.  -vii - xxxii. To some extent, the inefficient use of enterprise savings may be a trinsitioral problem, reflecting continuing price and other incentive distortions and the incompleteness of the enterprise reform. The fundamental issues of che definition and location of state enterprise ownership rights, however, need also to be resolved. Under the socialist commodity economy now envisioned for China, a Aubstantial proportion of output is to be subject to the discpleine of market forces, and the performance of managers is to be measured, in large part, by the profits earned. The motivation of managers to produce efficiently is relatively easily achieved by the payment of bonuses in direct relation to the profits earned. International experience suggests, however, that incentives consistent with the long-term profitability and survival of the enterprise require that the decision-makers have sotie interest in the evolving value of the enterprise's assets. xxxiii. Although goverNment agencies in China have benefitted from the profits of the enterprises they control, their "ownership rights" do not include the right to sell the assets or otherwise realize the value of the enterprises. Indeed, responsibility for enterprise supervision has frequently been shifted from one agency and level of government to another without compensation. The ephemeral nature of a particular agency's ownership rights may reduce its concern for the long-term profitability and value of the enterprise's assets and focus interest exclusively on short- term considerations. The dispersal of ownership rights among various levels and departments of government also raises the possibility that the interests of the nominal owners (i.e., the agencies) might diverge from the interests of the society as a whole. Such a divergence is manifested, when agencies exercise their authority to restrain competition, and each uses its monopoly power to maximize its own profitslor to pursue costly noneconomic objectives. In either case, economic efficiency is lost. xxxiv. Without clarification and, perhaps, some redefinition of socialist ownership rights in China, the vesting of investment decisions in decentralized govermaent agencies and their hired managers might not lead to greater investment efficiency. While not studying the ownership issue in detail, the report does offer some observations, based on economic theory and international experience, about the relationship between certain characteristics of ownership and the resulting quality of competition and the ,conomic efficiency of enterprise decisions. For example, both competition and economic efficiency are likely to suffer, when enterprises in the same industry and operating in the same market are owned by a single owner or agent of control, and when an enterprise is owned by a government agency having the authority to administer the prices of the enterprise's inputs and outputs, set its taxes, or otherwise regul.ate its external environment. xxxv. Even under socialist ownership, owner agencies appear to need some security in their control of enterprises and an interest in the value of enterprise assets to maintain a long-term perspective in their control over enterprise decisions. One possibility would be to represent an agency's ownership in the form of shares. Even thoughl the agency's right to sell the assets of the enterprise would continue to be restrict-ed, it might be allowed to sell all or a portion of its shares to another public agency at a negotiated price. (Over t'me, access to such share ownership could be extended to state-managed pension funds, insurance companies, or other contractual savings institutions, with any dividencs and capital gains thus accruing directly to the benefit of large numbers of workers and their families.)  -viii- xxxvi. Owners should be responsible for losses as well as profits. At the same time, government-owned enterprises should have the same protection under bankruptcy proceedings as other enterprises--i.e., other claimants on an enterprise should not be protected at the government's expense. The recognition that ownership can be risky as well as profitable leads also to the concern that agencies that take on large ownership responsibilities may need to diversify their asset holdings to reduce their own vulnerability to changes in technology and customer demand. The representation of ownership in shares could facilitate that diversification. The Segaration of Ownershin and Management xxxvii. Regardless of the nature of ownership, the separation of ownership and management, that commonly occurs in large and complex enterprises, breaks the common interest that links managerial incentives with enterpriso performance and economic efficiency. Some control mechanism is therefore required, through which owners can exert their authority over at least the most fundamental decisions affecting the future growth and performance of the enterprise. One such mechanism is the board of directors. xxxviii. International experience has shown that boards of directors are imperfect vehicles for control, often effectively dominated by enterprise managers. Boards of directors for state enterprises have had particular problems, their members often chosen for political reasons rather than for their expertise. Despite these problems, no better device has evolved, and boards may provide a useful means ir. China for clarifying ownership and providing the needed separation of ownership from the government's political and regulatory concerns. If boards of directors are to be powerful and make constructive contributions to the operation of enterprises, they should obviously be composed of dedicated and knowledgeable people and not be used as honorary positions. xxxix. The delegation of authority to enterprise managers does not mean, of course, that they should not be held accountable for their decisions by the owners. Accountability requires, however, that the objectives be relatively few, clearly defined, and measurable. If state enterprise managers are now to be held chiefly responsible for achieving efficiency in their production and investment decisions, the ultimate accountability enforced by a competitive market is that inefficient enterprises will suffer losses, and their managers, unless reassigned, will lose their jobs. Profits and losses are not always the fault of managers, however, and boards of directors must use judgment in evaluating performance. xl. Many managers may be as motivated by opportunities for promotion and professional recognition as by monetary reward. The definition of an attractive career path for successful managers can thus provide strong incentive for good performance. Given the different skills required and the desirability of avoiding conflicts of interest, it may be advisable to separate the career paths of enterprise managers and government cadres, and mawagerial appointments from the civil service appointment process. The selection of top managers should be a responsibility of the boards of directors, perhaps subject to ratification by the owners. Top managers, in turn, should have a strong voice in the naming of middle-level managers. xli. China has begun to experiment in recent years with management contracts and the leasing out of all or part of an enterprise's operations as ways of establishing managerial autonomy and accountability. Such  -ix- devices may prove to be quite useful, but, given the greater information usually available to existing managers of an enterprise, care should be taken that the leasing and contracting processes be as open as possible to avoid collusion or other abuses. IV. EnterDrise Financial Issues Financial Manatemejtl xlii. Enterprise management in the prereform period involved practically no financial decisions by enterprise managers. Profit retention, greater managerial autonomy, and the growing availability and diversity of financial instruments give greater importance to enterprise financial management. As external controls are reduced, enterprises will need to institute internal monitoring and control systems to assure that funds are properly used. xliii. Managers, owners, and potential creditors all neEd a timely flow of reliable financial information indicating the basic heelth of the enterprise and alerting them to problems and opportunitiesi. Some changes in Chinese accounting practices, particularly as regards :he valuation of enterprise assets and the treatment of depreciation, could help to raise investment and financial efficiency. xliv. Sound financial management is currently discour ged by limitations on the returns enterprises can earn on their financial savings. Managers have little incentive, consequently, to hold more than minimal bank deposits, and prefer instead to borrow to meet most short-term liquidity needs. This tendency reduces banks' ability to mobilize financial resources, increases the demand for the resources that do exist, and makes banks and enterprises more vulnerable to any tightening of credit. Allowing enterprises higher interest on deposits and greater freedom to choose among a variety of financial assets would help to discourage wasteful spending, stimulate a more competitive financial system, and reduce the potential for macroeconomic instability. xlv. Financial management must also be concerned with risk. Debt financing obligates an enterprise to meet a fixed schedule of loan interest and amortization. In contrast, raising money through u.e sale of equity shares or other forms of risk capital allows the owners to share risks at the cost of also having to share future profits. These differences between debt and equity financing can have important implications for the long-term survival of the enterprise. Because the enterprise is not obligated to pay any return to equity holders, it is better able to withstand a period of low or negative profits and to take the risks associated with investment and innovation. The higher the ratio of an enterprise's debt to its equity, on the other hastd, the greater the chance of either high profits or serious losses and the possibility of bankruptcy to its owners. xlvi. Although not an immediate problem for most state enterprises, as the economic reform continues, the sustained growth and stability of China's enterprises will require new sources of risk capital. Retention of profits will be a major source of equity financing, but may not be sufficient, particularly for enterprises that have received relatively little grant capital in the past, and for new, rapidly expanding enterprises. Banks and workers may also be potential sources of limited amounts of such financing. The potential of pension funds and Insurance  -xv companies, which are important sources of equity funding in other countries, is discussed below (para. lxxiv). The Treatment of Unsuccessful Enterpisgs xlvii. If government is no longer to bear the full risk of enterprise losses, a bankruptcy law is needed to specify the procedures to be followed when an enterprise is found to be insolvent, and to define how tiie interests of the different parties with claims on the enterrrise will be settled. In drafting such a law, it is important to find a middle ground between rules so lenient that owners and managers are motivated to incur large debts and declare bankruptcy to avoid payment, and so severe that assets that could be made productive with better management are liquidated. xlviii. Bankruptcy provides an ultimate sanction and means or adjudicating claims on insolvent enterprises, but many enterprises in trouble can be rehabilitated by less drastic measures. Among these are the rescheduling of debt, accompanied by a clear plan for resolving present inefficiencies; the sale of some enterprise assets; and merger with other enterprises, provided that the combination results in a more efficient and competitive enterprise rather than a forced subsidization of the inefficient enterprise h,y a more efficient partner. The Fin4ncina of Social Security and Worker Housing xlix. Competitive enterprises will not be able to introduce the innovations and efficiency improvements necessary for their survival, while, at the same time, guaranteeing the jobs, pensions, and other benefits currently enjoyed by urban workers in China. Alternative mechanisms are therefore needed to provide the minimum pension and other protections deemed essential, while also allowing the resource mobility necessary to achieving the efficiency gains sought by the reform. 1. The coverage and benefits of China's pension system are fairly broad by international standards, and its costs are quite high. The number of retireos is growing rapidly, relative to the active population, and a sigt.ificant retirement "bulge" will appear after the year 2000. Only the introduction of a relatively high cointribution rate now would enable the system to accumulate reserves and avoid a very large increase in contributions later. If such reserves were accumulated, they could represent an important source of investment financing. Individual and group life insurance policies could also provide useful vehicles for attracting rapidly growing household savings, particularly in the rural areas, to longer-term financial assets. li. International data show that urban Chinese households spend far less on housing, as a proportion of total expenditures, than do families elsewhere. Although urban incomes and consumption expenditures have grown rapidly in recent years, housing rents have remained unchanged, in some cases for as long as 30 years. Urban housing is generally provided by state enterprises to their workers for life. For government to take over the entire responsibility for housing at subsidized rents would involve an insupportable fiscal burden. Regardless of ownership, an increase in housing rents seems called for and is essential if urban families are to be motivated toward home ownership, which is a stated intention of the reform.  -xi. lii. As home ownership becomes more attractive, China will need to develop a system of housing finance. Inasmuch as a larse proportion of the existing urban housing stock is currently owned by enterprises, a simple transition form of finance would be for the enterprises to give their workers loans by transferring the ownership of the houses to them and deducting payments from monthly wages. V. The Banking Svstem ntrotion liii. In the past, China's banks and other financial institutions were essentially fiscal agents, providing enterprises the credit needed to comply with government administrative directives and auditing payments to ensure that funds were used for their designated purposes. In the course of economic reform, financial institutions are to become increasingly responsible for the mobilization of financial savings and the channeling of those savings to efficient investments. Toward that end, financial institutions themselves will have to operate more autonomously and take responsibility for their own profits and losses. liv. Before the beginning of economic reform, the Chinese financial system resembled a monobank system, in which all financial transactions were handled by one or a few specialized banks with a virtual absence of other financial institutions or financial markets. The principal institution was the People's Bank of China (PBC). State enterprises were required to hold their money in the form of deposits in the PBC, which monitored and cleared '.1 interenterprise transactions and provided cash for the payment of wages and purchases of agricultural goods. The PBC was also the source of all operating credit and offered savings deposits for households. In addition, the People's Construction Bank (PCBC) served as fiscal agent for the transfer of state budgetary resources to enterprises in support of the capital construction investments mandated by the plan. The Bank of China (BOC) operated as the state monopoly over foreign exchange operations and international payments. lv. Since 1979, the PBC has gradually moved toward operating exclusively as a central bank, its rural credit activities being tranferred in 1979 to the Agricultural Bank of China (ABC), which is also responsible for supervising the activities of rural credit cooperatives. PBC's urban industrial and commercial credit operations were transferred to the newly created Industrial and Commercial Bank (ICBC) in 1984. At the same time, the banking system has become increasingly important as a source of enterprise financing and, although still principally engaged in short-term credit, is now also providing medium-term fixed asset financing and lending to nonstate aS well as state-owned enterprises. Bank interest rates have been progressively raised since 1979 to reflect more closely the supply of and demand for credit. lvi. Despite the modest decentralization of bankin6 that has occurred (and the appearance of new nonbank financial institutio,ns and financial instruments), competition remains extremely weak in the financial sector. Although some overlap of functiors has begun to develop, each bank is limited to a particular sector or class of service. They are still not responsible for profits and losses, and governments, particularly at the local levels, continue to influence credit decisions. The expectation that decentralized decision-making will lead to more efficient investment  -xii- decisions depends heavily on the efficiency with which the financial system mobilizes and channels resources. It is important, therefore, that the enterprise reforms be accompanied by parallel reforms in the financial system. Banking Structure and Ownershio lvii. Given the strong relationship between the quality of competition and efficiency found in financial as well as production activities, a number of alternatives for making the banking sector more competitive might be considered. Some options, not mutually exclusive, include permitting the existing specialized banks to offer a wider range of overlappIng services in competition with one another, while allowing enterpribes greater freedom to choose their banks; allowing existing investment and trust companies to enter into banking operations; permitting the rural and urban credit cooperatives also to become full-fledged banking institutions; and decentralizing the ownership of the present branches of the specialized banks to lower levels of government or regional organizations. lviii. Given the possibility that decentralization of bank ownership could lead to greater interference by local governments in bank decisions, it would be essential that the central government, via the enforcement of appropriate antimonopoly laws, assure that banks are free to compete in each other's territories, thereby limiting any bank's ability to depart from efficiency and creditworthiness criteria in its lending decisions. l x. A competitive banking system cannot be achieved overnight. The introduction of the necessary laws, the training of managers and staffs, the application of new management techniques and information systems, the perfection of indirect instruments of monetary control, and the needed improvement of bank supervision will all take time. Efforts could begin immediately, however, to improve the general quality of services provided by the banking sector and to train the large numbers of managers and staff personnel that will be needed. The Future Role of People's Construction Bank lx. If interest rates on capital construction loans were raised sufficiently, the PCBC could become a full-fledged investment bank. To play this role, it would require a substantial independent capacity to evaluate projects and manage risk. In addition to, or instead of, this more market-oriented activity, the government might continue to use PCBC to manage the financing of government-sponsored projects in the production or infrastructure sectors. To the extent that such projects are to serve noneconomic objectives, any required subsidies should be explicitly financed by the government budget. In addit:'n to protecting the solvency of the investment bank, the explicit treatment of subsidies will help to assure that their justification is regularly evaluated in the light of overall budgetary constraints. (This argument for budgetary financing of credit subsidies applies also to any subsidy programs managed by other financial institutions.) Interest Rates lxi. Price flexibility is a crucial element its the competition among enterprises, and zonceptually the price of loanable funds, the interest rate, is no different. Nevertheless, most countries, including China, have  -xiii- chosen to regulate interest rates, particularly the deposit and loan rates of their commercial banks. As investment and saving decisions are decentralized, financing from the budget is reduced, and both investment and financing decisions are increasingly made on the basis of profit criteria, the interest rate will become a central variable in determining the level and direction of investment and savings. lxii. Nevertheless, given the distortions that remain in the price system more generally and the lack of competition in the financial system, the freeing of interest rates is not recommended at the present time. It would be desirable. however, to adjust interest rates more flexibly, both to make monetary policy instruments more effective and to offer savers a more attractive real rate of return in the face of changing inflationary expectations. lxiii. Of particular concern is the low interest rate paid on enterprise savings accounts. A higher interest rate would improve the incentive to defer expenditures for worker welfare or to refrain from making low-return investments. It would also serve to stimulate horizontal resource flows, through the banking system, from enterprises with excess funds to enterprises with high-return investment possibilities. lxiv. Low interest rates on loans for capital construction investment may, in the past, have been offset by the greater administrative control associated with them and by enterprises' lack of concern for financial costs. Economic reform, however, makes the upward adjustment of these rates increasingly important for directing financial resources to the most efficient irvestment possibilities. lxv. Chinese eredit policies have long included the earmarking of credit for specific purposes or the offering of interest subsidies on loans for specific activities. In the absence of a well functioning capital market, and with price distortions elsewhere in the economy, there may be some justification for such continued intervention in credit allocation. The situation should be constantly reviewed, however, on a case-by-case basis, and it would be desirable to phase out credit suasidies as other price reforms proceed. Bank Management and Staffing lxvi. Chinese banks need to improve the services they provide to customers. Such lsprovements would eventually be forced by competition, but there is no reason to wait. For example, branch bours could be adjusted now in accordance with customer convenience, with extra staffing t'rovided for peak hours. Over time, bank personnel will need to become tncreasingly skilled in the evaluation of alternative resource uses, borrower creditworthiness, and the management of risks. Administrative procedures, accounting systems, liquidity management, information collection and evaluation systems, loan documentation and monitoring, etc. will all have to be modernized. Shortages of trained personnel capable of introducing these reforms at the bank level is one of the most difficult and urgent problems facing the banking system. VI. Regulation of the Banking System Monetary Policy  -xiv- lxvii. Control of monetary expansion is crucial to the avoidance of inflation, while assuring adequate liquidity in support of economic growth. The success of the economic reform depends importantly, therefore, on the ability of People's Bank to control the growth of the money supply. At the same time, the reform itself affects the manner in which monetary policy can be carried out. Although progress has been made in the introduction of indirect levers of monetary control, the banking system remains exceedingly vulnerable to the pressures of government agencies and the continuing expectation that the banks will automatically meet all working capital requirements. lxviii. Economic reform will necessarily affect the financial behaviors of both households and enterprises. In its response to these changes and in its conduct of monetary policy generally, the People's Bank, like central banks everywhere, will need substantial insulation from the political pressures of government at all levels. The achievement of an independent central bank in China may be especially difficult during this period of transition, and a firm commitment by the Government will be required. Toward this end, it should be clearly established that the responsibility for determining monetary policy resides in PBC headquarters, and that it is the function of PBC branches to execute that policy. As transportation and communications in China improve, it would be desirable to greatly reduce the number of PBC branch offices. Prudential Regulation and SuDervision lxix. Because banks provide the basic payments mechanism in almost all economies, there is a particular public interest in assuring their stability and sound management. At the same time, because of the high liquidity of their liabilities, banks are exceedingly vulnerable to shocks to the economy. Thus, banking is among the most regulated and supervised economic activities in all countries. lxx. Banking regulations are commonly aimed at assuring that individual banks maintain adequate risk diversification and sufficient capital to withstand a reasonably large loan failure rate without jeopardizing their solvency. These regulations need to be accompanied by supervision and on- site examination by trained inspectors with appropriate penalties imposed when,violations are found. To avoid conflicts of interest, the supervisory agency must enjoy substantial independence in performing its duties and should treat all banks in an evenhanded manner. It is generally good policy, in order to maintain objectivity of judgment and freedom from local pressures, to rotate bank examiners regularly from one locality to another. lxxi. In addition, in order to prevent unfounded fears about a bank's solvency from causing large-scale withdrawal of deposits, many countries have institited programs of government-guaranteed deposit insurance. Given the significance of savings deposits in the financing of investment in China, and the possible concerns for safety that might arise as banks become responsible for profits and losses, the introduction of such insurance could be particularly important. Central banks are often called upon as well to serve as lenders of last resort, assisting banks that are unable to meet sudden large withdrawals. This is an essential central banking function but must be uqed sparingly in the interest of maintaining macroeconomic stability and not relieving banks of ultimate responsibility for their prudent and efficient operation.  -xv- VII. Other Fnacial Insttutions lxxii. Given the high liquidity of most commercial bank liabilities, banks are not always well suited to provide the large amounts of long-term lending or equity financing needed by investors. Thus, most modern economies have evolved a variety of institutions to offer savers and investors a broad range of alternative instruments with longer-term and higher risk/return characteristics. A considerable amount of experimentation in the development of nonbank financial institutions and securities markets is now under way in China. As this activity grows, it will increasingly need the guidance of clear rules and regulations. Nonbank Financial Institutons lxxiii. A variety of nonbank financial institutions now exists in China, including investment and trust companies, leasing companies, pension funds, and the state insurance company. Like the banks, the nonbank financial institutions are principally state-owned and tend to be specialized by function and geographical area. Although potentially an important center of competition among themselves and with the banking system, competition currently remains limited. lxxiv. Of particular interest for the future could be the development of such contractual savings institutions as insurance companies, pension funds, and provident funds, which in most countries are second only to the banking system as mobilizers of household savings. Contractual savings institutions are stable investors, which, because of the long-term predicteability of their liabilities, are able to hold relatively risky and illiquid assets. As noted earlier, the growth of such institutions could facilitate labor mobility and enterprise efficiency by removing the burden of these services from the enterprises. Mutual insurance companies, which are owned and raise their equity funds entirely through the premiums paid by their many individual policyholders, could also offer an attractive way to promote the development of China's capital market in a manner compatible with principles of socialist owership. Securities Markets lxxv, Although still accounting for only a small fraction of total financing, the economic reform has resulted in a rapid increase in the volume and variety of financial instruments issued by enterprises and available to savers. Bonds, quasi-shares, co_mrcial paper, equity joint venture arrangements, mutual aid associations, and other forms of horizontal transfers of funds are appearing both spontaneously and as parts of government-sponsored experiments. A well developed financial market provides competition to other financial institutions and enhances resource mobilization by offering savers and borrowers a wider range of asset and liability options. Financial mrkets can also reduce the costs of intermediation compared to face-to-face transactions or dealing through banks and other financial intermediaries. lxxvi. China's capital merket currently consists of a narrow range of financial instruments, including government bonds and one-year bonds issued by the specialized banks. True equity securities do not yet exist. The issuance of bonds and other fixed-income securities by banks, nonbank financial institutions, and selected enterprises could be substantially expanded in China as a source of funds for long-term fixed investments,  -xvi- including infrastructure. The creation of a stock market does not appear to be an immediate priority, but, as already noted, it would be desirable, especially for new and fast growing enterprises, to attract new sources of risk capital. lxxvii. Although permitted by the current banking regulations, an interbank market has been slow to develop in China, probably because of past interest rate regulations (recently removed) and the reluctance of local authorities to see surplus funds go to other localities. If more banks and competition are introduced into the banking sector, the encouragement of an active interbank market will be of highest priority. lxxviii. A number of concerns are expressed in China regarding security market development. The principal among them are: (i) that the expenditures being financed are inflationary; (ii) that the expenditures being financed are wasteful; (iii) that funds are being drawn out of the banking system; (iv) that issuing enterprises may exceed their debt- servicing capacities; and (v) that markets may invite fraud and speculation. Each of these concerns has some justification under present circumstances in China. lxxix. The concerns that securities markets could contribute to inflationary pressures and draw money from the banking system both reflect weaknesses in current control over credit expansion. These problems should disappear, as the underlying difficulties of macroeconomic management are resolved, and interest rate controls are gradually relaxed. In the meantime, some limits on the volume and quality of new securities will have to be maintained. lxxx. It is probably true that some resources mobilized by the financial markets are being poorly utilized. The reasons, however, appear to derive from the still incomplete nature of price reform, of enterprise responsibility for profits and losses, the general lack of competition, etc.-- factors also affecting the use of bank credit, retained profits, and other decentralized sources of funds. lxxxi. The possibility that enterprises may borrow beyond their debt- servicing capacities, thus creating future problems of solvency, is heightened by the continuing expectation that government will ultimately accept the burden of any financial mismanagement. Another aspect of the problem is the lack of uniform accounting standards and disclosure requirements that would permit potential lenders to evaluate the debt- servicing capacities of the issuers of securities. Economies with well developed securities markets typically require enterprises to publish complete, audited financial statements, before their securities may be issued. The enforcement and supervision of public disclosure requirements are also important for the avoidance of fraudulent market behavior. lxxxii. Restrictions on secondary trading of securities may, in part, be intended to avoid speculation, market manipulation, and potentially destabilizing changes in asset prices. Such restrictions, however, also reduce the liquidity of financial instruments and increase lenders' risks by locking them into a commitment, regardless of how their perceptions of the issuer may change over time. The possibilities for manipulations of, and large swings in, asset prices can be reduced instead by the enforcement of trading regulations--e.g., limits on the proportion of an outstanding issue that can be traded at one time--and by public disclosure requirements.  -xvli- lxxxiii. To functiots effectively, in any event, securities markets require an organized and regulated system with clear rules governing issuance and trading. At present, the authority for financial market regulation rests with People's Bark. Because of potential conflicts of interest arising out of responsibility for both the banking system and the securities market, may countries have preferred to create a separate regulatory agency to oversee the latte . Like the bank regulatory agency, such a securities commission would adee the power to enforce its regulations and considerable insulation from political pressures. VII. Government Investment Decisions lxxxiv. Despite the decentralization occurring as part of the economic reform, government will continue to be a major decision-maker and source of investment finance in China. Moreover, the reform opens a new role for government planning agencies with greater emphasis on policy planning, the broader long-term perspective planning, and greater focus on intersectoral linkages. Investment Planning lxxxv. Investment planning in China has been carried out in two parallel processes: the formulation of annual aggregate plans and individual project approvals. Aggregate investment targets are set by the State Planning Commission (SPC) and apportioned along territorial and ministerial lines. Lower-level agencies enjoy considerable authority for determining the composition of investment within their overall quotas. lxxxvi. Investment planning in the future is to focus increasingly on the medium- and long-term and less on annual plans. This chapter recommends a multiyear investment planning approach that seeks to assure consistency between aggregate investment and macroeconomic constraints, coordinate investment decisions with other facets of economic policy, and facilitate implementation in accordance with intersectoral and intrasectoral priorities. The appruach includes the formulation of a medium-term macroeconomic framework to project the major ecoromic parameters within which the plan will operate and to highlight related policy issues; e.g., the need to increase government savings or modify enterprise incentives through the use of indirect levers in order to meet the plan's financing requirements and output objectives. Many relevant policy issues are only perceived, and a consensus developed on how to resolve them, as a result of the planning process itself. It is thus helpful for the planning process to be an open one that encourages the consideration of different points of view. lxxxvii. Inasmuch as investment projects often take several years to complete, and first-year expenditures are typically small relative to those of later years, it is useful to formulate multiyear investment programs, detailing the monies needed and the expected sources of financing to avoid costly work stoppages for lack of funds. Not all changes in the relevant macroeconomic conditions can, of course, be anticipated, but the program can provide a base from which changes can be made and the assessment of priorities that will guide those changes. Some countries, to prepare for the possibility of having to make later expenditure cuts, identify a acore" investment of highest priority projects that would be protected from all but the most drastic program reductions. China may wish to experiment with this technique. There are strong reasons to avoid, however, the establish-  -xviii. ment of special funds or other forms of revenue wearmarking" that may protect certain programs or categories of expenditure but only at the cost of weakening fiscal policy and causing greater instability to other expenditures. Project Plannlng lxxxviii. Project evaluation in China has often suffered from inadequate preparatory work and a tendency toward suboptimal project scale, as available resources are stretched to acecmodate the many competing claims of the different ministries and localities. It would not make sense for a central planning agency to duplicate the expertise of the line agencies or enterprises that prepare the projects, but it should be staffed with, or otherwise have access to, the necessary skills and adopt adequate methodologies to assure that high-return and cost-effective projects are being chosen. Given the decentralization that has occurred in the project approval process, local government capacities in this regard are in particular need of upgrading. lxxxix. As noted earlier (para. lx), consideration is being given to shifting all or part of project evaluation responsibility for state- financed investments to the PCBC. A financial institution separate from the government administration mAy offer the advantage of being less subject to political pressures. An evaluation and approval agency within the government, on the other hand, may be in a better position to enforce fiscal discipline and coordinate investment selection with other policies. One option that could offer the advantages of both approaches would be a development bank, whose board of directors included experts from outside the government as well as representatives of the relevant finance and planning organs of the government. The bank's managers would be held responsible for ass'.ring the growth of the bank's capital, and, toward that end, the bank would generally finance projects which, although not imediately attractive to purely profit-oriented financial institutions, were expected to become economically viable within a reasonable period of time. To the extent that the development bank is also called upon to finance noneconomic projects, any subsidies required should be explicitly covered from the fiscal budget in order to protect the bank's capital. Projeot Implementation xc. Project implementation in the past in China was characterized by unusually long completion times and high costs. MCaterials shortages led to frequent delays, and, because the materials were allocated to the investing enterprises, the construction companies were unable to consolidate them and utilize them efficiently. Recent measures to open up the markets for construction materials and to institute competitive bidding for construction contracts are useful steps toward improving this situation. IX. Gvrment Revenus xci. The decentralization of investment financing implies a change in the way the central government finances its own future expenditures and in the way it influences the size and composition of investment. The structure of taxes can have an important influence o.-. the efficiency of investment and the manner of its financing. The Ned to Viden the Tax Base  -xix- xcii. China's present tax structure places a heavy burden on the state enterprise sector and could impede its future growth and efficiency. New taxes on enterprise profits have been introduced in recent years, partly in an effort to recoup the revenues lost to the central government. Meanwhile, the profits of collective enterprises are taxed at a lower rate, and the resultant revenues have been growing more slowly than the output and profits of such enterprises. Special tax incentives are also offered to foreign investors as well as to enterprises in particular industries or locations. xciii. one approach to future profits tax reform would be to integrate existing special taxes into a single, comprehen4ive enterprise profits tax, applicable at equal rates to all enterprises, regardless of sector, size, location, or form of ownership. This would contribute to economic efficiency by bringing production and investment decisions more in line with market signals. The comprehensiveness of a single tax structure would also give greater leverage to macroeconomic statilization policy. xciv. China's personal income tax, because of its high exemption levels and the still low average level of incomes, reaches few, if any, taxpayers. With rising incomes, however, growing numbers of individuals will become legally subject to this tax, which could be an important instrument for limiting income inequalities. The income tax is a difficult tax to administer, however, and preparation of the necessary staff and infrastructure needs to begin well in advance. xcv.. The agriculture tax is one of China's oldest taxes. As a consequence of low rates, numerous exemptions, and the disappearance of the communes, however, revenues are small and have been declining in recent years. The rapid growth of farm incomes suggest that a higher contribution might be appropriate. A substantial upgrading of tax administration would be required to assure equitable collection of the agriculture tax. Alternatively, farmers could be incorporated into a comprehensive income tax. The Need for Greater Tax Neutrality xcvi. The tax system can be a powerful economic lever for affecting economic behavior and the structure of the economy, potentially influencing investment, consumption, production, savings, and locational decisions. Because it is such a powerful lever, deviations from neutrality should be carefully evaluated and monitored to ensure that they achieve the desired purposes and at an acceptable cost to the budget. xcvii. Although the profits tax ostensibly regularized enterprise tax liabilities, a large element of ad hoc negotiation in {he setting of the "adjustment tax" leads to different effective tax rates for each enterprise. This differential treatment is frequently defended as necessary to compensate for other distortions--e.g., prices--but they appear just as likely to be exacerbating distortions. xcviii. Other variations in profits taxation are intended to encourage or discourage specific activities. However, the large number of different incentives offered makes it difficult to judge their overall impact on either enterprise behavior or on the revenue losses to the budget. Especially contradictory of other policy objectives is the subsidization of borrowing provided by permitting enterprises to deduct loan amortization  -xx- from before-tax profits. The elimination of this deduction would help correct the preference now given to debt in contrast to equity financing, to consuming rather than saving retained profits, and to using capital rather than employing labor. x