China - Reform and the role of the Plan in the 1990s

Report No. :11117 Type: (PEU.JB) Title: REFORM AND THE ROLE OF TIIE PLA Author: WORLD BANK Ext.: 0 Room : Dept.: WORLD BANK COUNTRY STUDY China Reform and the Role of the Plan in the 1990s ' --  A WORLD BANK COUNTRY STUDY China Reform and the Role of the Plan in the 1990s The World Bank Washington, D.C.  Copyright i 1992 The International Bank for Reconstruction and Development/TEm WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing September 1992 World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. Some of the reports are published in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. 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ISSN: 0253-2123 Library of Congress Cataloging-in-Publication Data China : reform and the role of the plan in the 1990s. p. cm. - (A World Bank country study) ISBN 0-8213-2230-3 1. China-Economic policy-1976- 2. Central planning-China. 3. Economic forecasting-China. I. World Bank. II. Series. HC427.92.C46454 1992 338.951-dc2O 92-30849 CIP  Abstract The focus of this report is on the government's reform and development policies for the decade of the nineties. The assessment is based on a review of the successes and failures of China's reform experience over the past decade. Particular attention is paid to the key reform areas that appear to deserve increased attention. Development policies are examined on the basis of the Eight Five-Year Plan, with a particular focus on transport policies. The report also reviews economic developments during the 1990-91 period, when China was emerging from recession. Finally, after examining reform and development options, the report develops a set of alternative scenarios for the economy for the rest of the decade, depending upon the set of policy options selected.  -iv- CURRENCY EQUIVALENTS Up to December 15, 1989 Up to November 29, 1990 At March 31, 1992: $1.00 X Y 3.72 $1.00 Y 4.72 $1.00 - Y 5.46 Y 1.00 $0.27 Y 1.00 - 0.21 Y 1.00 - $0.18 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS 7thFYP - Seventh Five-Year Plan, 1986-90 8thFYP - Eighlth Five-Year Plan, 1991-95 CAAC - Civil Aviation Authority of China CIECC - China International Engineering Consulting Corporation CTRI - Comprehensive Transport Research Institute DRC - Development Research Center of the State Council GNFS - Goods and Nonfactor Services IMF - International Monetary Fund IOT - Investment Orientation Tax ME - Ministry of Materials and Equipment NOC - Ministry of Communications MOF - Ministry of Finance MOR - Ministry of Railways NDA - Net Domestic Assets NFA - Net Foreign Assets PBC - People's Bank of China SAEC - State Administration of Exchange Control SOE - State-Owned Enterprise SPC - State Planning Commission SRC - State Commission for Restructuring the Economic System TVE - Township and Village Enterprise SCIC - State Communications Investment Corporation  -v - Preface This report is based on a mission which visited China in May/June 1991. Mission members were Peter Harrold (Principal Economist, Mission Leader, Reform Issues), Fernando Montes-Negret (Senior Economist, Macroeconom- ics), Michael Bell (Deputy Division Chief, IMF, Macroeconomics), Anand Rajaram (Economist, Development Plan), Thomas Chan (Consultant, Reform Plan), Hernan Levy (Principal Transport Economist, Transport Plan) and Tejaswi Raparla (Research Analyst, Statistics and Projections). The mission received -eat support from the World Bank Resident Mission in China, and especially Chen Xingdong (Economic Officer) and Dai Dongchang (Transport Operations Officer), as well as from Zhang Shaojie (Local Consultant). The mission was hosted by and received great support from the Minis- try of Finance. In particular, MOF put together a very capable counterpart team to work with the mission: Liu He, Ning Jizhe, Wu Qing, Zhu Zhixin, Li Tiejun, Yang Weimin, all of the State Planning Commission; Wang Hong, Ministry of Finance; Wang Huijiong, Li Poxi, Development Research Center; Fan Hengshan, Systems Reform Commission; and Huang Deha.i, Comprehensive Transport Research Institute. The team was led by Zhang Shengman (World Bank Department, Minis- try of Finance), and support was ably coordinated by Wu Jingkang. The team produced nine background papers in preparation for the mission. The mission visited Henan Province, where it was hosted by the local Bureau of Finance. This was a most useful and enlightening visit, the results of which are illustrated at various points in the report. The support of all the Chinese counterparts is duly acknowledged, for without it, this report would not have been possible.  - vii - Table of Contents Page No, EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . xi I. RECENT ECONOMIC DEVELOPMENTS . . . . . . . . . . . . . . . . 1 A. Introduction . . . . . . .. . . . . . . . . . . . . . . . 1 B. Monetary and Credit Policies . . . . . . . . . . . . . . 1 C. The Real Sector . . . . . . . . . . . . . . . . . . . . 8 D. Price Developments . . . . . . . . . . . . . . . . . . . . 15 E. The State Sector . . . . . . . . . . . . . . . . . . . . 18 F. The External Sector . . . . . . . . . . . . . . . . . . 25 G. Conclusions . . . . . . . . . . . . . . . . . . . . . . 31 II. CHINESE REFORM EXPERIENCE TO DATE . . . . . . . . . . . . . 34 A. Introduction . . . . . . . . . . . . . . . . . . . . . . 34 B. The Initial Conditions . . . . . . . . . . . . . . . . . 34 C. China's Reform Style . . . . . . . . . . . . . . . . . . 37 D. China's Major Reform Steps . . . . . . . . . . . . . . . 42 E; The Impact of Reforms . . . . . . . . . . . . . . . . . 49 F. Reform Priorities . . . . . . . . . . . . . . . . . . . 60 G. Some Tentative Conclusions . . . . . . . . . . . . . . . 66 III. CHINA'S DEVELOPMENT PLAN, 1991-95 . . . . . . . . . . . . . 70 A. Introduction . . . . . . . . . . . . . . . . . . . . . . 70 B. The Evolution of Planning . . . . . . . . . . . . . . . 70 C. Role of the Plan in the 1990s . .............73 D. The Macroeconomic Framework and Development Policy . . 75 E. Planning to Correct Market Failures . . . . . . . . . . 85 F. Planning for the State Sector . . . . . . . . . . . . . 94 G. Conclusions and Issues for Future Plans . . . . . . . . 97 IV. THE REFORM PLAN . . . . . . . .. . . . . . . . . . . . . . . 100 A. Introduction . . . . . . . . . . . . . . . . . . . . . . 100 B. Reform in 1989/91 . . . . . . . . . . . . . . . . . . . 100 C. The Reform Plan . . . . . . . . . . . . . . . . . . . .. 103 D. The Implied Shape of the Reformed Chinese Economy . . . 116 E. Timing, Sequencing and Reform Style . . . . . . . . . . 117 F. Links with the Development i'lan . . . . . . . . . . . . 120 G. Specific Reform Areas . . . . . . . . . . . . . . . . . 122 H. Conclusions . . . . . . . . . . . . . . . . . . . . . ..127  - viii - Page f V. THE PLAN FOR THE TRANSPORT SECTOR .S............ . 131 A. Background . . . . . . . . . . . . . . . . . . . . . . . 131 B. The Eighth Five-Year Plan, 1991-95 . . . . . . a . . 0 . 133 C. Financing of the Plan . . . . . . . . . . . . . . . 141 D. Sectoral and Institutional Reforms . . . . . . . . . . 146 E. Conclusions . . . . . . . . . . . . . * . . . . * * 151 VI. SCENARIOS FOR TIE CHINESE ECONOMY . . . . . . . .... 154 A. Introduction..................... . . . . . . . . e . 154 B. The Base Case . . . . . . . . . . . . . . . . . . . 155 C. Scenario 2: Slow Policy Change/Macroeconomic Instability. . ........... . . . . . . . . . 158 D. Scenario 3: Accelerated Reform . . . . . . 0 . . . . . 160 E. Conclusions . . . . . . . . . . . . . . . . . . . . . 1S2 END NOTES . .* ................ . . . . . . . e e . . . . 0 163 BOXES IN TEXT 1.1 Fiscal Policy in Henan Province . . . . . . . . . . . . . 23 3.1 The 7th FYP and its Outcome . . . . . . . . . . * . . ... . 72 3.2 Development Plans in an Interior and a Coastal Province . . 88 3.3 Eleven Measures to Revitalize SOEs . . . . . e . . . . 0 . 96 4.1 The Future Chinese Policy Framework . . . . . . . . . . . . 118 5.1 Organizational Reforms in Air Transport and Ports . . . . . 132 5.2 Transport Development and Market Integration . . . . . . . . 136 5.3 Growing Role for Local Railways . . . . . . o . . . . . . . 139 5.4 The Bank for Public Works, Mexico . . . . . . . . e . . . . 145 TABLES IN TEXT 1.1 Relative Composition of Reserve Money . . . a .. . . . . a 4 1.2 Specialized and Comprehensive Banks: Total Deposits a . . . 7 1.3 China: Sources of Growth of GDP (1988-90) . . . 0 0 . . . . 9 1.4 China: Comparative Supply and Demand-Side Contributions to Growth . . . . . . . . . . . . . . ... .. . . .. 10 1.5 China: Price Adjustments During 1990/91 . . . . . . . . . . 18 1.6 China--State Budgetary Operations, 1986-91 . * .. . . . 20 1.7 China: Selected Indicators for the SOEs, 1984-91 . . . . . 25 1.8 Sources of Foreign Exchange, 1988-90 . . . . . . . . .. . . . 28 1.9 China: Balance of Payments, 1986-91 . . . . . . . . a . . . 29 1.10 China: Effective Exchange Rate, 1986-91 . . . . . . . . . * 30 2.1 Output Gains in the Reform Era . . . . . .. . . . . . . .. 50 2.2 Consumption Indicators, 1978 and 1988 . . . . . a. . . 51 2.3 Economic Gains during the Reform Era . . . . . . . . . a . . 52 2.4 Changing Role of the State . . . . . . . . . . . . . .* . . 54 2.5 Shares of Industrial Output of Nonstate Industry . . . . . . 55 2.6 Structure of Government Expenditures, 1978-90 . . . . . . . 57 2.7 Trade in the Chinese Economy, 1978-90 . . . . a . . . . . . 59  - ix - Page No. 3.1 8th FYP Objectives and Targeta . . . . . . . . . . . . . . . 78 3.2 Provincial Allocation of State Investment, 1981-90 ......86 3.3 Labor and Employment Under Eighth Plan . . . . . . . . . . . 90 3.4 Employment Elasticity of GNP by Sectors, 1980-89 . . . . . . 91 3.5 Possible Employment Growth, 1991-95 . . . . . . . . . . . . 91 3.6 Share of Services in Current GDP in Selected Countries, 1965-90 . . . . . . . . . . . . . . . . . . . . . . . . . . 93 3.7 Sectoral Composition of China's GNP, 1979-90 . . . . . . . . 93 3.8 Performance of Industrial SOEs in Central Budget . . . . 95 5.1 Financing of 8th FYP Highway Program, Henan Province . . . . 143 6.1 The Base Case, 1989-2000 . . . . . . . . . . . . . . . . . . 155 6.2 The Slow Reform Scenario, 1989-2000 . . . . . . . . . .. . 159 6.3 The Accelerated Reform Scenario, 1989-2000 . . . . . . . . . 161 GRAPHS IN TEXT 1.1 Monetary Aggregates . . . . . . . . . . . . . . . . . . . . 6 1.2 Real Gross Value of Industrial Output and Retail Sales . . . 11 1.3 Commercial Inventory Changes .................. . . . . 14 1.4 Retail Price Inflation . ............................ . . . 16 CHARTS IN TEXT 2.1 Ownership Shares in Industrial Output . . . . . . . . . . . 56 2.2 Regional Development and Nonstate Industry . . . . . . . . . 58 5.1 International Comparison of Transport Networks . . . . . . . 134 5.2 Passenger and 'reight Volumes in China . . . . . . . . . . 138 MATRIX IN TEXT 4.1 Reform Priorities and the Reform Plan . . . . . . . . . . . 128-29 ENDNOTES ANNEX A RMSM-X Model for China STATISTICAL APPENDIX  - xi - Executive Summary Introduction i. China entered the decade of the 1990s at a crucial stage both in its own development path and in the world economy. China emerged in 1990 from a painful period of economic stabilization and from the domestic and interna- tional repercussions of the May-June 1989 events. It did so with an apparent determination to avoid the sharp economic cycles of the 1980s, or at least to dampen the amplitude of such cycles. Moreover, after a period in which it seemed the government was tending to look towards administrative measures to solve economic problems, there has been a clear revival of attention to reform issues, and a renewed recognition that only further, economic reform can solve the fundamental issues facing the economy. Moreover, this recognition comes at a time when the state sector itself faces increasingly severe problems, to which solutions have yet to be clearly identified. Finally, all these domes- tic issues are occurring at a time of rapid changes in the world economy, not only in terms of unclear global economic prospects, but more particularly, the collapse of the former USSR, and a less benign international environment for China. ii. This report focuses on China's recent economic developments and future prospects in the light of the reform and development strategy set out in the "Outline of the Ten-Year Program and of the Eighth Five-Year Plan for National Economic and Social Development", which was prepared in 1991. In particular, it proposes a range of economic policies and reforms that may be necessary to achieve a strong, sustainable growth path over the rest of this decade. These proposals are based on an analysis of the reform experience of the past decade, and the lessons to be drawn both from this experience and from China's macroeconomic performance over this decade, especially the 1988- 91 period. iii. The report concLudes that China's economic prospects are extremely bright if the government continues to pursue a strong program of economic reform and appropriate development policies. Many of the economic problems that China has encountered in recent years are considered to be the conse- quence of incomplete reforms, and the judgement of the report is that these problems can be avoided or minimized in the future if the program of reform is widened and deepened across a broad policy spectrum, which is spelled out in the report. Moreover, it appears that the likelihood that such reforms will continue has increased in recent months. Current' Economic Situation iv. By early 1990, the serious inflationary pressures of 1988 had been eliminated and the economy was showing signs of severe strain from the auster- ity policies. In particular, the state sector, with much less flexibility in adjusting to the recessionary environment, was facing cash flow difficulties in the face of sluggish demand. From the second quarter of 1990, the authori- ties began to relax monetary policy, and in particular to expand working capi- tal for state owned enterprises, as well as relaxing investment controls. Thus, in deciding to reflate the economy, the government chose the same two instruments that had been employed in 1989 to dampen inflation. Once it got underway the recovery in output was very rapid indeed, and the key issue  - xii - raised by the speed and manner of the recovery is its sustainability and whether it will lead the economy straight back into a strong upswing, bringing a return to inflation and overheating. v. Money and credit policies have been the key area of economic policy once more. From an original planned credit growth of 14 percent, the level of loans outstanding grew by over 22 percent for the year in 1990, and particu- larly large increases went to finance SOEs' inventories and the purchase of the record grain harvest. This was repeated in 1991, when loans grew by 19 percent, again well above the 14 percent target. This source of money supply growth was further boosted by the very large balance of payments sur- plus, and broad money rose by 28 percent in 1990 and by a similar level in 1991. J'imilar trends in credit growth appear to be continuing in 1992, with gS-wth rates well over 20 percent in the first six months, which is signifi- cantly above the credit target. Fortunately, both households and enterprises proved to be very willing to increase their savings, and total bank deposits grew by a remarkable 30 percent in both 1990 and 1991, with particularly fast growth of enterprise deposits, as enterprises rebuilt deposits which had been run down in 1989 in the face of the austerity program. This rapid growth of savings meant that the build-up of inventories and of foreign exchange reserves was achieved without increasing inflationary pressures, and inflation has remained at very low levels, falling to only 2.9 percent in 1991. How- ever, it has also meant that banks' profitability and the ratio of their equity to assets have fallen significantly. vi. The real impact of the austerity program in China was felt from mid- 1989 to mid-1990, a period which saw no real growth. As noted, once recovery began, it took off very rapidly. In the 18 months after October 1990, indus- trial output grew by over 15 percent, close to 1988 levels. Overall GDP grew by 5.6 percent in 1990, and 7 percent in 1991. The first six months of 1992 saw their growth accelerate to 10.6 percent. While agriculture and trade were key sources of growth in 1990, this shifted to industry and investment in 1991. However, while output was recovering rapidly, final demand was not, and the "sluggish market" became a major issue as retail sales grew by only 1.9 percent for 1990 as a whole, having declined substantially in the first half. As a consequence, inventories grew very rapidly. Although data is very poor in this regard, inventories probably reached a peak of about 20 percent of GDP in early 1991 and were particularly large in those sectors where production is dominated by SOEs, such as textiles and large consumer durables. A concerted effort was made in late 1991 to reduce these inventories, with some initial success. The level of consumer demand recovered in 1991, growing at 13 per- cent, and is continuing to grow in 1992, but inventories still remained high, given the high growth of industrial output, although inventory accumulation appears to have stopped. vii. It should be no surprise that the economic downturn strongly affected China's state-owned enterprises, especially in terms of profitability. However, while profits fell, and about one third of SOEs were losing money, this had no noticeable impact on tax receipts. Overall, the open fiscal deficit was only 2 percent of GDP in 1990, and 2.6 percent in 1991, higher than projected (primarily because of higher administrative expen- ditures) but still manageable. However, MOF was, for the second year, unable to service maturing bonds held outside the household sector. The greater  - - xiii - impact has been on the public sector's borrowing requirement more broadly defined, which appears to have risen from 8 percent of GDP in 1987 to 11 per- cent in 1990, and a similar level in 1991. viii. The strongest area of performance in China in the last year has been the external sector, with record external surpluses in 1990 and 1991. Exports have continued to perform very well, in response both to declining domestic demand, and to improved incentives, notably successive real devaluations. As a result of the austerity program and intensified restrictions, imports fell 10 percent in 1990, but as the economy recovered, imports registered growth of almost 20 percent in 1991, a trend which is continuing in 1992. The trade surplus was accompanied by a recovery of tourism and by greater willingness to lend to China, and therefore the current account surplus of $12 billion in each of the two years resulted in a cumulative $26 billion improvement in reserves during 1990/91 to the equivalent of about ten months of imports. ix. China has therefore had in many ways an enviable emergence from recession, with rapid output growth accompanied by low inflation and a strong external position. However, while fully recognizing this success, three issues arise: (a) the strong growth of credit could, if permitted to con- tinue, lead China back to an inflationary situation, especially given highly liquid savings. For this reason, a more moderate credit stance, consistent with non-inflationary growth, is now called for, and restoration of the provi- sions for index-linked interest rates would be desirable in case of a change in inflationary expectations; (b) the severe difficulties of the SOEs during the last three years merit a focus on restructuring and reform issues for these enterprises; and (c) the growing open and quasi-fiscal deficit, now of the order of 9 percent of GNP (through forced lending by banks to loss-making SOEs) merits attention not only to the SOEs, but also more generally to fiscal and financial sector reforms. Development Policies x. The new five-year plan can be seen as part of an evolving pattern for the role of planning. Over time, the plans have gradually developed from being an exercise in numerical targeting and in calling for mobilization of effort, to an attempt at a realistic macroeconomic assessment and statement of government intent. The previous plan (the 7th FYP, 1986-90) had suffered from a macroeconomic framework that was very divergent from actual government policy, and from an attempt to provide targets and goals for sectors beyond the government's direct influence. While the present plan has more of a focus on the macroeconomic framework and development policy, and on the reforms necessary to achieve those goals, it continues to suffer from some of the same difficulties as past plans, and as such, it runs the risk of rapidly becoming irrelevant. xi. In this report, we assess the plan in the light of the three key roles for planning: the provision of a macroeconomic framework and set of accompanying policies that can act as a guide for the actions of others; plan- ning to correct market failures, which can be expected to be quite serious under China's partially-reformed economy; and planning for the state sector and specifically for the avoidance of bottlenecks. With respect to this  - xiv - latter role for planning, particular focus is paid to what is probably the single most important sector in this regard: the provision of transport. xii. The macroeconomic framework and its associated development strategy and policies calls for a much more moderate pace of growth (6 percent per annum) than in the recent past, and while the framework appears in general to be easily achievable, there are three particular issues: (a) It suffers from a rather incomplete coverage--for example, by the absence of trade and external accounts projections--and from a lack of exposition of macroeconomic policies. (b) More serious, it suffers from the same problem as the 7th FYP, in that actual economic policy in the first year of the Plan differed radically (by promoting rapid growth) from the Plan, not least because the Plan's target was below the growth level that was both desirable and achievable. (c) While the development strategy seems sensible, there is very little exposition of policies and programs to support the achievement of the strategy, such as pricing policies for the key 'basic' indus- tries. xiii. Where the exposition is fairly explicit is with respect to indus- trial policies. These show a continued move away from mechanical targeting policies and associated credit allocations towards greater use of indirect instruments, such are the new Investment Orientation Tax. While this trend is welcomed it will need to accelerate and to place less emphasis on the use of countervailing distortions, such as this tax. xiv. With respect to policies to correct market failure, we have focussed our analysis on two such issues: balancing the pace of regional development; and creation of sufficient employment generation via the tertiary sector. This plan does not have regional policy as a key instrument of the overall development strategy, as was the case of the 7th FYP with its emphasis on the coastal development strategy. Rather, it focusses on ways to maximize growth in each region, and to re-distribute income as appropriate. However, the Plan pays no attention to the major policy issues that appear to have generated the present pattern of income distribution, notably pricing policies, provincial economic policy-making discretion, and the location of SOEs, If the authori- ties are concerned about emerging patterns of regional income distribution, these seem to be the issues to be addressed. While general economic reform and progress will, therefore, be the key to continued poverty reduction in China, recent analysis has shown there to be pockets of absolute poverty in certain resource-poor areas, where more direct action is warranted. xv. The Plan recognizes the heavy burden of employment creation facing the economy, and has only modest aims in this regard. For example, it antici- pates that open unemployment will rise from 2.5 percent to 3.5 percent and that no significant progress will be made on reducing underemployment. How- ever, it recognizes the potential key role of the services sector in creating employment opportunities, by targeting for a 9 percent growth in the tertiary sector. However, while the target seems appropriate and potentially achiev-  -xv- able, no supporting policies are outlined. Among the more important that seem to merit attention are those that would create an enabling framework for the sector, including efficient licensing systems, access to credit and contract- ing out of various government services. xvi. Increasingly, the more traditional aspects of the plan, in terms of investment programming and output targeting, will have to be limited to those parts of the economy where government provision of services or production of goods will remain dominant, as in the transport sector (paras. xxviii.- xxxii.). Similarly, there will be the need for continued government attention to issues concerned with improving the environment. One key issue for the future will be industrial restructuring for the SOEs, especially given the increasing burden they are placing on the budget. However, while the policy framework includes some appropriate concerns--such as the granting of trade rights and the reduction of mandatory plans--too much of the solution is being sought through technical improvements and through disguised subsidies, espe- cially on credit and via tax exemptions. In short, as restructuring policies are refined, they should concentrate more on the removal of disadvantages imposed on the SOEs and less on the provision of countervailing advantages. China's Reform experience since 1979 xvii. In identifying reform priorities for the coming period, it is appro- priate to start from an assessment of the successes and failures of past reform experience. Such an assessment can now be done on an objective basis because of the passage of time and the availability of recent research results. However, in drawing broader lessons from this experience, it is important to understand clearly the initial conditions under which the reform was launched. Three factors are key in China in this regard: the absence of severe macroeconomic crisis at the start of the program, so that harsh stabi- lization measures could be avoided; the state of agriculture, with its good infrastructure but poor incentives; and the presence of Hong Kong, as a source of inspiration, expertise and investment. xviii. As the reform program has developed in China, four distinctive fea- tures in terms of reform style have emerged: (a) Gradualism and Experimentation. China has tended to spread changes over several years, and usually after considerable experimentation and adaptation. Its large size and provincial structure foster such experiments and make such an approach appropriate, if not inevita- ble. (b) Partial Reforms. One of the distinctive features of China's reform has been the apparent success of partial reforms within sectors, notably the two-tier price system, which has created a situation in which marginal decisions are based on market prices, and market skills can be learned without economic dislocation. (c) Decentralization. Decentralization of decision-making power to enterprises, individuals and local governments has been a key theme of reforms, enhancing microeconomic incentives and creating a strong interest group in favor of continued reform deepening.  - xvi (d) Self-Reinforcing Reforms. Reforms in one area created pressures for matching reforms in other areas, and policymakers have in general seen their interests served best by meeting such pressures with new reforms rather than by administrative protectionism, albeit some- times with a considerable lag. xix. China's approach to reform has been demonstrably effective, particu- larly in terms of its impact in four distinct areas: (a) Output and Welfare. GNP has grown about 50 percent faster during the reform period, especially in light industry and services. This has resulted in enormous improvements in consumption levels (more than doubled over the decade) and in the lifting of 160 million from poverty since 1979. (b) Productivity. The key to this has been that growth has come via productivity gains, which were close to zero in the 1949-79 period, but accounted for 3-4 percent per annum of growth during reforms. (c) The Role of the State. The state used to dominate savings and investment, but now, most savings are generated by individuals and enterprises, and investment is financed by retained profits and banks. Even more dramatic is the changing role of state-owned enterprises, which accounted for almost all output in the prereform period, but now nonstate industry employs almost 100 million people and produces 45 percent of industrial output. (d) Trade. The share of trade in GNP has risen from just under 10 per- cent in 1978 to over 30 percent in 1990, and there are over 20,000 sino-foreign joint ventures in operation. xx. Despite the great progress achieved to date, the gradual approach means that much remains to be done, and reform priorities can be identified in six key areas: (a) enterprise reform, especially the question of ownership reform for the state-owned enterprises; (b) financial sector issues, especially the reduction of forced policy lending by commercial banks; (c) fiscal reforms, to replace the present revenue generation system with a diversified tax system; (d) external reforms, and especially reduced import protection; (e) further price reform, particularly for such distorted prices of raw materials and agriculture; and (f) social sector reforms, primarily those which improve labor mobility by converting nonwage benefits such as housing and pension rights, to wages. In addition, the government will need to be increasingly concerned in this decade with issues that affect the envi- ronment and with poverty alleviation, although these topics are not addressed directly in this report. The adequacy of the reform plan's proposals in each of these areas is discussed in the next section. xxi. The final issues addressed in considering China's reform experience to date are concerned with conclusions of more general applicability that can be reached, and the sustainability of the approach. Five key features of China's experience seem to have wider applicability: agriculture as an entry point for reform; the success of "marketization" of the enterprise sector, instead of privatization; the key role of changing the interest of the bureau-  - xvii - cracy; the impact of developing exports at an early stage; and the role of the state in maintaining stability by looking after the most affected. xxii. Given the lack of historical precedents for the Chinese approach, the question of its sustainability overtime must be addressed. On balance, it is judged that the approach is sustainable, because: (a) the Chinese reform has generated intensive development, and the consequent generation of true welfare changes; and (b) China has generally responded to the problems arising out of reform by deepening reforms, which suggests that deep crisis can be avoided via a process of continued incremental change. Nevertheless, the key will be in how well China responds to the reform challenges still to be addressed (para. xx). Reform Prospects xxiii. During three years of stabilization curing 1988-91, when reforms were given less prominence, a surprising degree of progress was achieved, not least because of the imperatives of the fiscal situation. Most important, several key prices were adjusted substantially, notably the prices of grain, oilseeds, coal, and transportation, in some cases for the first time in 20 years. In addition, a new round of trade reform and extension of the coverage of the foreign exchange adjustment centers lent further impetus to the export drive. Finally, reform experiments were extended and widened in various areas, notably in housing and in the separation of profits and taxes. xxiv. The prospects for a deepening of economic reform have improved sharply of late, since the visit of Deng Xiaoping to Southern China in the spring, and various reform initiatives have either been launched or are being actively prepared at the local level since that time. However, this report takes as its point of basic reference the reform plan contained in the 8th FYP issued in 1991, and some of the observations made about the shortcomings of this plan are already being addressed by the Chinese authorities at various levels. Nevertheless, these shortcomings merit continued attention as the government reviews its overall reform strategy and its specific reform pro- posals in preparation for the 14th Party Congress later in 1992. XXV. This reform plan is a rather comprehensive statement of intention in all the major areas of reform, some of which are new and of considerable interest and importance. Notable among these are: a program to expand the number of enterprise groups to 100 from the present 57, with groups which would cross ministerial, bureau or even provincial boundaries, and be the locus of many other reforms initiatives, such as the formation of joint stock companies; a renewed emphasis on price reform and a clear commitment to elimi- nate major distortions, even if not necessarily via markets; a new focus on reform of the distribution system, and on the formation of an integrated national market; a major initiative on social sector reformss especially hous- ing, social security and unemployment and medical insurance; and further reforms of the investment system. xxvi. In reviewing this reform plan, it can be seen to be relatively com- prehensive, and to propose appropriate reforms in many areas. One general issue is that, in most areas, it suggests only preparatory actions during the 8th FYP, leaving implementation to the 9th FYP, although recent announcements  - xviii - suggest this position may already have been overtaken. Such caution seems neither desirable, nor necessary, given the state of the economy, and the state of preparation. This would seem to be the case in particular for price reforms, and for fiscal reforms. In addition, four key areas of reform seem to merit particular care or greater attention. (a) Ownership Reform Issues. Enterprise reform remains the central challenge in China, particularly those reforms which will enable SOEs to become efficient and competitive. The government has very little to say at present as to how it will represent its ownership function in the future. Experience suggests that the preparation time in this regard can be extensive, so this would call for a much more aggressive program of reform experiments, especially in such' areas as joint-stock companies, and the separation of profits from taxes, as well as the improvement of the legal framework and accounting systems. Nevertheless, while there are clear incremental gains to be made in China's SOEs, it must be noted that interna- tional experience casts doubt on the ability of the SOEs to attain the same level of efficieney as private enterprises, so long as the SOEs remain dominant. (b) Enterprise Groups. The great interest in this idea is that such groups would cut across the present interest structuz that currently impacts on the performance of the SOEs. As such, it is a development to be very much welcomed, but with one major caveat. Great care will need to be taken with respect to competition policy, as such groups could rapidly create monopolistic positions. In particular the role of the TVEs should be invoked in this regard, both as a direct source of competition, and potentially as leading enterprises of such groups. A key to the achievement of greater efficiency gains could be the future taking over of loss-making SOEs by efficient, aggressive nonstate-owned enterprises. (c) Financial Sector Issues. The government hopes to create banks that are fully responsible for credit risk, but at the same time, it continues to impose tight control on banks to ensure that its key enterprises and key projects receive funding, which is clearly con- tradictory with the first aim. The solution seems to be to find alternative methods to fund these priorities, and the suggested route is to convert the State Investment Corporations into true investment banks issuing bonds to generate financing for such investments. (d) Role of the External Sector. While much progress has been made on the export policy framework, and the performance of China's external sector has been remarkable, it continues to have relatively little impact on the domestic economy, except in provinces such as Guangdong and Fujian. In particular, the external sector--with respect to both imports and foreign investment--is seen only as a source of foreign capital and technology, and not as a source of competitive pressure for innovation for domestic enterprises. This crucial link between an outward orientation and enterprise reform deserves to be revisited as the reform plan is refined.  - xix - xxvii. It seems clear that there is once again a major impetus for reform in China, and a recognition that only via reform can further efficiency gains be achieved. Moreover, it is also beginning to be seen that, far from the economic cycles of Tihe latter 1980s having been caused by reform, rather they reflected inadequate reform in the area of the development of instruments of indirect economic management. Indeed, only with further, deeper reforms can there be economic gains while avoiding the strong cyclical pattern of the 1980s. However, the reform program seems to be weakest in the very areas that would do most to strengthen macroeconomic management capability, and it is therefore in these same areas that incremental attention should be addressed. The Transport Plan xxviii. The transport sector has long been one of the main bottlenecks in the economy, serving not only as a constraint to the achievable rate of non- inflationary growth, but also as an impediment to efficiency gains through greater integration of the national market. As such, the plan for the trans- port sector should be seen very much in the light of its links to the rest of the economy, and to the achievement of the development and reform plans. xxix. The reason that this sector has for so long been a constraint on the rest of the economy is clear: there have been decades of underinvestment in the sector, not least because of the importance attached to regional self- sufficiency during the pre-reform era. It must also be recognized that any economy would have had difficulties keeping up in terms of the provision of transport infrastructure with the rapid overall rate of economic growth in the 1980s. When compared to other countries, China has a very small transport network in terms of population and area covered. China's investment in trans- port in the last ten years has been 1.4 percent of GDP, compared with 2-3 percent for countries such as Korea, India and Brazil. xxx. The plan for the transport sector gives an appropriate emphasis to transport investments that would help to integrate the national market. In particular, there is a focus on two key areas: expansion of highways and efficiency improvements on the railways. For the latter, the main priority continues to be to relieve coal transport bottlenecks, but the focus is on double-tracking, electrification and related improvements rather than new lines. The railways will dominate overall investments in the sector, at an estimated Y 116 billion in today's prices, about 0.8 percent of GNP. The highways plan is based on traffic growth projections of 14-15 percent per annum, with a particular focus on interprovincial highways and expressways, reflecting the key importance being attached to the role of the trucking industry. Given good progress in the 1980s, less attention is given to ports, but civil aviation is expected to expand rapidly, at about 12 percent per annum, with major focus not on network expansion but on airport improvement and increased numbers of aircraft. xxxi. There are three key issues that emerge within the transport plan; financing, pricing and competition, and the role of the trucking industry. (a) Financing. While there may be some increased budget allocation for transport investments, the main source of incremental revenue is seen as higher use charges, both at the national and local levels.  - xx - While there is much scope for this, and it is an appropriate direc- tion--especially with respect to tariff adjustment--care will need to be taken to select fitting instruments. This is especially so in highways, where there is an absence of sufficient use charges on fuels, but the presence of many toll roads. A greater reliance on the former could lead to efficiency gains, especially in terms of road selection by users, and average speeds. Similarly, use of bonds could be expanded as a source of financing for some high uti- lization, high quality facilities, However, with full financing by no means assured, government will need to monitor this carefully and take appropriate actions if necessary. (b) Pricing and Competition. Major progress has been made during the 7th FYP period in eliminating some of the most serious pricing dis- tortions. Nevertheless, further progress is needed if the sector is to generate the necessary investment resources. In contrast, truck- ing tariffs are unusually high, and five to ten times unit rates on the railways. The key to stimulating road-rail competition is bringing these rates closer together, and while some further adjust- ment of rail tariffs can be expected, much will have to come from lowering trucking rates through encouraging competition. In partic- ular, this should come through stimulating the role of TVEs in the provision of trucking services. (c) The Trucking Industry. This is the most backward sector in relative terms in China's transport sector and will have a critical role to play in transport diversification, and new initiatives are needed to increase efficiency and lower costs. The key issue is the common practice of trucking via own account trucks, with very few common carriers, and these mainly publicly owned. One consequence of this is very low load factors, as many trucks return empty. Similarly, the low load-bearing capacity of most roads reduces the average truck size. In addition, as noted, this is a sector where small enterprises could play a key role given the opportunity. xxxii. In short, the 8th FYP for transport appears to give the sector the priority it requires and attempts to remedy longstanding neglect. However, the pricing and institutional reforms that have been identified are critical to the achievement of the aims of the transport plan, and thus to the wider aims of the development plan itself. Macroeconomic Prospects xxxiii. China's macroeconomic prospects have been considered under three scenarios, which differ in terms of the policy framework to be adopted and the associated efficiency gains. The base case assumes a moderate, steady pace of reform over the decade. The accelerated reform case assumes that the pace of reform quickens in the next year or so, particularly in price, financial, trade and f iscal reforms, with consequent gains in efficiency. The slow case, in contrast, assumes a repetition of some of the economic cycles of the 1980s, with their associated reform cycles. In each case, however, we see a strong growth performance, and continued creditworthiness. The key distinctions between the  - xxi - cases are in the degree of efficiency improvement, and consequently in the level of welfare. xxxiv. The base case assumes that China makes good progress with a wide range of reforms, on an accelerated schedule compared with the reform plan. It thus assumes that growth will be on average rather higher than the government target at about 7.5 percent per annum. The impact of reform is reflected in a gradually falling investment requirement over the period, from 37 percent of GDP in 1990, to 33 percent by the end of the decade, indicating efficiency improvements. Inflation control is assumed to remain a priority for the government--hence the lower rate of growth than in the 1980s--and inflation is expected to be in the 5-6 percent range over the period. Any sign of a return to double-digit infla- tion is expected to generate the sort of firm policy response that was witnessed in 1988-89. The growth pattern under this scenario is projected to be in line with the 8th FYP's targets, with industry showing more moderate growth, at about 6-8 percent in GDP terms, while the services sector, and especially transport, finance and information services, is projected to be the leading source of growth, at around 9 percent per annum. xxxv. The external sector is also projected to continue to expand its role in the economy, with both exports and imports growing faster than GDP. The export (volume) growth rate is projected to be in the 7.5-9 percent range, while we expect a very rapid growth of imports for a year or two, to eliminate the present trade surplus, and thereafter growth at about 8 percent. The strong emphasis on technical modernization in the development strategy is thus expected to be reflected.in particular in higher capital goods imports, which we expect to grow at about 10 percent a year. Nevertheless, the current account deficit is not expected to exceed 1.3 percent of GDP, keeping debt within manageable levels, and in fact declining as a share of GDP. With relatively small additions to the level of reserves, the net external financing requirement barely exceeds the current account deficit. In the base, about $4 billion is projected on average to come from foreign direct investment, and thus the net external borrowing requirement is about $6 billion per annum on average over the course of the decade. The distribution of such borrowing between official and private sources is expected to be a bit more favorable to China than in the last decade, as more and larger sources of official financing are now available. xxxvi. The slow reform scenario assumes that with less progress in reform in particular with respect to the development of macroeconomic management capabil- ity, and the state-owned enterprises, there would be a consequent repetition of the stop-go cycles of the 1980s. It is not expected that this would have a severe impact on the average growth rate--even in 1989, at the height of the austerity program, GDP grew by 4.6 percent--but rather it would be reflected in three things: a higher investment requirement and thus significantly lower rate of consumption growth; a higher average inflation rate, nearer to 10 percent per annum on average, because of the high rates during the "booms"; and a lower rate of foreign direct investment, because of the economic instability. xxxvii. The accelerated reform case assumes a much more aggressive attack on these issues, commencing in the next year or so. This would have three primary effects: GDP would rise by an average of about 8.5 percent a year in response to efficiency gains, as experience has shown in China that reforms launched in periods of macroeconomic stability have a strong growth effect as people respond  - xxii - to the new incentives; similarly, more products would become export-competitive, raising average trade levels; and in response to these reforms, foreign direct investment would rise rapidly. In the higher scenario, FDI would rise to about $5 billion per annum, while in the slow case it would be about $3 billion, the lowest it has been in the recent past. In the slow case, therefore, debt ratios are somewhat worse than the base case, while in the accelerated case they are better. It is to be noted that in this scenario we do not project any increase in the rate of inflation above the base case of 5-6 percent rate, associated with the higher growth rate. This is because it is assumed that the accelerated reform would strongly impinge upon fiscal and financial areas, which would reinforce the effectiveness of macroeconomic management under conditions of rapid growth. Nevertheless, we would urge caution in permitting sustained growth above this rate, and specifically sustained growth rates of 10 percent per annum or more, as these would cause overheating and inflation, which would interfere with the orderly implementation of reforms. xxxviii. Under all three of our scenarios China would continue to enjoy a strong creditworthiness position, with all indicators remaining very good. Total debt outstanding stood at only 15.4 percent of GDP in 1991, and under our base scenario, this would fall to 11.4 percent in the year 2000, and stay between these two levels throughout the decade. Even in the low case, debt would not rise above 16 percent of GDP, and would be only 9.4 percent in the high case. The associated debt service levels also remain manageable, at a peak of 11.5 per- cent of export earnings in 1992, falling to only 7.7 percent in the year 2000. Iowever, even with these modest indicators, it should be emphasized that in a different sense they cannot be regarded as conservative, in that the absolute level of debt would double over the decade to $113 billion in the year 2000, placing China among the ranks of the most highly indebted developing countries in absolute terms, which would mean that China would account for a very substan- tial proportion of total new net debt to developing countries over the decade. xxxix. In summary, these scenarios demonstrate two things: first, the policy decisions that will be taken will have a clear and measurable impact on economic variables, and we have attempted to indicate the orders of magnitude of such impact under different policy frameworks; second, our assessment has shown that within the range of what could be considered likely outcomes, China is likely to continue to enjoy healthy growth, and to continue to enjoy a strong credit- worthiness position. xl. This report has reviewed China's past experience with reform and its prospects for the future. It finds great opportunities for China to move forward and enjoy a continued strong economic performance if these opportunities are grasped. But this will require strong reform efforts by the Chinese government, for without changes to the present policy framework, it is unlikely that the current problems facing the economy could be solved. The indications are that these opportunities will indeed be grasped, and that the decade will see economic gains at least as great as those of the 1980s.  I. RECENT ECONOMIC DEVELOPMENTS A. Introduction 1.1 By early 1990, the serious inflation and overheating of the economy that had been seen in 1987/88 had been overcome, and the more pressing issue had become the need to restart the economy, which was suffering heavily from the downturn in economic activity.' Therefore, this chapter is concerned primarily with the manner of China's emergence from recession since 1990. In many respects, this recovery has been remarkable, in that growth in 1991 has returned to the 7 percent region, with industrial output growth well into double figures, but without the reemergence of inflation or with any negative impact on the external accounts. This growth has returned partly as a natural upswing in activity at the end of the cycle, and even more as a result of explicit government policies to stimulate economic activity. 1.2 There are two main questions that this chapter attempts to address. First, there is the question of the sustainability of the recovery in view of the way in which it has been initiated. Just as there was a heavy reliance on a tightening of money and credit policies in 1989 to overcome inflation, so has there also been a heavy reliance on such policies to stimulate the recov- ery, which raises the obvious question of whether this approach is likely to generate inflationary pressures. The second issue is therefore whether the recovery can be sustained without a repetition of the earlier economic cycles that have characterized the Chinese economy in the 1980s, or at least with a dampening of their amplitude. 1.3 To a large extent, these past cycles have occurred because of the inadequacy of the macroeconomic policy instruments and, in particular, the lack of indirect economic levers available to the government.2 More recently, however, such tools have been used with greater frequency and effect, which permits more emphasis to be placed on an assessment of the effi- cacy with which such tools have been used. The links between these assess- ments and the rest of the report should be clear: continued success of the reform process and attainment of the goals of the Eighth Five-Year Plan (8th FYP) depend on achieving sustainable growth with macroeconomic stability, primarily through indirect management of the economy.3 B. Monetary and Credit Policies Background 1.4 In 1988, Chinese policymakers confronted an economy which was seri- ously overheated, as described in detail in the World Bank's last two CEMs on China. This prompted the authorities to act quickly, shelving plans for fur- ther price adjustments and adopting a stabilization program, consisting both of direct administrative interventions, including reduction of state invest- ment outlays by 20 percent, freezing prices of basic goods and tight credit controls and also more intensive and successful use of indirect policy levers. Nominal interest rates on deposits were increased by more than four percentage points, and the People's Bank of China (PBC) introduced long-term indexed savings accounts to reverse the depletion of deposits and to encourage longer-  -2- term savings. These decisive actions proved to be highly effective in reduc- ing inflation and, by restoring confidence, curbing inflationary expectations. By mid-1989, the annualized monthly rate of inflation, seasonally adjusted, had already declined to single-digit levels. However, measures to establish stricter controls over aggregate demand led to a sharp contraction of output growth and sales, especially in late 1989. The authorities were therefore faced in 1990 with a very different set of economic problems to address. Money and Credit in 1990 and 1991 1.5 It is clear that, by early 1990, it was appropriate to begin to reflate the economy, as inflation was no longer a short-term threat, and the economy presented Chinese policymakers with a somber picture characterized by rising (open and disguised) unemployment; rising losses or declining profits in most large and medium state-owned enterprises (SOEs);l/ stagnant indus- trial production and retail sales; rising tax and credit delinquency and major fiscal difficulties; and high and rising inventories of unsold (industrial, agricultural and finished) goods. Moreover, 1989 had witnessed considerable disintermediation in the banking system, with rapidly growing interenterprise arrears (the so-called "debt-triangle"), and all these circumstances called for some relaxation by PBC of monetary policy in 1990.2/ 1.6 The 1990 Credit Plan. PBC's initial credit plan was Y 170 billion for the year--about the same as the actual credit growth for 1989--but this was raised on three occasions, for a total credit expansion of Y 276 billion in 1990, yielding total credit growth of 22.3 percent for the year. Several factors explain this outcome. First, it was decided to guarantee credit to key state enterprises and projects. The result was, on the one hand, that as much as 80 percent of working capital loans, above the initial credit target, went to finance the rapid accumulation of inventories, and to finance opera- tional expenditures of SOEs such as overdue taxes and salaries. In addition, as much as Y 30 billion went to help clear interenterprise arrears, which reached a peak of Y 158 billion during the year. At the same time, as part of the reflation strategy, the level of fixed asset investment financed by the specialized banks rose significantly, which facilitated a growth in investment by state-owned units of 11.5 percent, and it was these units that explained 1/ "Poor economic performance in enterprises constitutes the main obstacle to China's economic development and the major cause of its financial difficulties. In the past few years, the enterprises' economic perfor- mance has been fairly poor, and the profit from their operation, both the total and the part turned over to the financial authorities, has been steadily decreasing, while their losses have been increasing," Report on the Implementation of the State Budget for 1990 and on the Draft State Budget for 1991, Speech delivered at the 4th Session of the 7th NPC Con- gress on March 26, 1991 by Finance Minister Wang Bingqian. 2/ Three alternative strategies were discussed in China for the reflation of the economy: to relax credit, especially to SOEs; to expand public investment rapidly in economic infrastructure; or to increase incentives for consumption through reduced interest rates. While all three were used to some extent, it was the first that received greatest attention.  -3 the entire growth in fixed investment in 1990.3/ It should be noted that restraints on lending to Township and Village Enterprises (TVEs), introduced in the last quarter of 1988, were also relaxed, and Rural Credit Cooperatives (RCCs) increased their lending to TVEs by 35 percent in 1990. 1.7 Second, it was necessary for the authorities to guarantee credit to procure 1990's bumper grain harvest, and PBC allocated above Y 20 billion in new credits for this purpose. In practice, credits to procure agricultural crops are excluded from the credit ceiling, as illustrated by the credit plan of Henan, a largely wheat-producing province.4/ Third, PBC executed the 1990 credit plan with more flexibility than in previous years, letting its provincial branches exceed their credit quotas by up to 5 percent, allocating any excess among the banks under their jurisdiction. It also appears to be the case, however, that this flexibility was exercised primarily in the inte- rior provinces and the Northeast, and that credit limits continued to be applied quite strictly in the major cities and coastal areas. 1.8 Most of the additional requests for credit financing during 1990 could not be foreseen by the monetary authorities at the beginning of the year, such as unplanned losses of SOEs and to finance crop purchases, given the record grain harvest. In other countries, these are usually the responsi- bility of the budget authorities. This delayed progress in achieving a more complete separation of fiscal and monetary functions. As a result of the expansionary pressures from the domestic front, Net Domestic Assets (NDA) grew at an annual rate of 24 percent by the end of 1990. 1.9 The credit plan for 1991 postulated a reduction of credit expansion from the Y 276 billion level of 1990 to Y 210 billion in 1991, with Y 145 bil- lion for working capital, Y 10 billion for agriculture and Y 50 billion for 31 In spite of the rapid growth of these longer-term loans in 1990, their relative importance in the stock of total outstanding bank loans remained under 10 percent. 4/ Henan's Credit Plan. Henan's 1990 credit plan amounted to Y 12.4 billion (4.5 percent of the national plan), well in excess of the allocation at the beginning of the year. This outcome reflected the rapid growth in lending to procure agricultural products, as well as the increase in working capital loans to finance the accumulation of unsold inventories in the province., A feature giving an expansionary bias to the provin- cial credit plan results from the flexibility and practical automaticity in exceeding the planned allocation of funds when bank loans are granted to procure agricultural goods. The initial credit plan for 1991 foresaw an expansion of Y 6.3 billion, which was seen as clearly insufficient by the provincial authorities, given the demand for working capital to finance inventories and the rapid growth in bank deposits in Flenan which has resulted in a rapid rise in excess reserves. Demand pressiures gener- ally become particularly intense during the second semester of the year, when--given the marked seasonal pattern of the demand for agricultural loans--about 70 percent of total annual bank credit is granted, while banks are extremely liquid and anxious to expand their assets in order to improve their financial results.  -4- fixed capital investment. Most of the proposed cuts would have fallen on working capital, based on the notion that the recovery of retail sales would reduce the need for bank credit for this purpose. As it turned out, the credit plan target was exceeded by Y 80 billion in 1991, driven in part by a credit infusion of an additional Y 35 billion to reduce the problem of inter- enterprise debt as well as credit to finance recovery from flood damage.5/ Seasonally adjusted domestic credit increased by more than 20 percent in each of the first three quarters (23.8, 20.5 and 22.9 percent, respectively) before slowing to 14.4 percent growth in the final quarter of 1991. The 1992 credit plan had not been finalized at the time of preparation of this report, and the PBC intends to monitor the performance of the economy and inflation in the first two quarters before setting a target for the year. The Governor of the PBC indicated, however, that credit expansion in 1992 would not exceed the nominal increase in 1991, i.e., Y 345 billion. 1.10 Net Foreign Assets, Reserve Money and Broad Money. The balance of payments strengthened sharply in response to the stabilization program (see Section E below). Therefore, the financing of the large accumulation of for- eign reserves in 1990 and 1991 ($11.6 and $14.1 billion respectively) provided an additional impetus to the overall level of domestic liquidity, while also changing the relative composition of the monetary base significantly. As shown in Table 1.1, Net Foreign Assets (NFA) trebled from 5 percent of PBC's reserve money in 1988 to over 16 percent at the end of 1991. In addition, due to the rapid growth of international reserves, broad money (M2) grew faster than Net Domestic Assets in 1990 and again in 1991, albeit by a smaller amount, fueling a rapid growth of reserve money (see Graph 1.1).6/ Table 1.1: RELATIVE COMPOSITION OF RESERVE MONEY (Percentages) December 1987 1988 1989 1990 1991 Net foreign assets 4.6 5.1 6.6 10.4 16e0 Claims on financial institutions 86.1 83.6 83.8 78.3 72.6 Other domestic assets 9.3 11.3 9.6 11.3 11.4 Reserve Money 100.0 100.0 100.0 100.0 100.0 5/ Total domestic credit expanded by Y 345 billion in 1991. However, using the credit plan definition, credit expansion was Y 289.5 billion. 61 Since evidence in China indicates that broad money is a good leading indicator of inflation, targeting broad money may be an efficient way to achieve macroeconomic stability and reduce the frequency and amplitude of the business cycles.  -5- 1.11 One result of this growth has been the reversal of the decline in the ratio of excess reserves to deposits. With unchanged legal reserve requirements, the spectacular increase in bank deposits caused the ratio to double from 5.9 percent in 1988 to 13.5 percent at the end of 199i. The increase in bank deposits also allowed the rapid growth of credit to have minimal short-term impact on the price level, but this rate of credit expan- sion is clearly inconsistent with low and stable inflation in the medium term. Savings Deposits and Interest Rates 1.12 In 1989 total bank deposits grew by 19.3 percent, with household deposits rising by about 33 percent. In contrast, enterprise deposits rose only 5 percent, a steep decline in real terms, as enterprises were forced to draw down their deposits in the face of the shortage of credit, and to finance the rising level of interenterprise arrears.7/ In 1990, total bank deposits grew by 31 percent, a remarkably fast increase in real terms. Household total and time deposits continued to grow at annual rates of 30 and 41 percent, respectively, but it was the growth of enterprise sight and time deposits, by about 26 and 55 percent respectively, that caused this acceleration in total savings.8/ By the end of 1990, total deposits in the specialized and uni- versal banks had reached the level of Y 1,046 billion, equivalent to 60 per- cent of GDP (Table 1.2). This trend continued in 1991; by the end of the year, household deposits were 29 percent larger and enterprise deposits were 27 percent greater than in 1990, while total deposits had grown to Y 1,330 billion, or 67.9 percent of GNP. 1.13 The increase in household savings in 1990 and 1991, which was par- ticularly rapid in urban areas which accounted for 90 percent of growth, can be attributed to a mixture of policy and structural factors: (a) low inflationary expectations as a result of the impact of the aus- terity program, strengthened by an ample supply of agricultural goods and the reassuring presence of the indexation mechanism for longer-term deposits; 7/ Interestingly, however, enterprise term deposits, which accounted for only about 17 percent of total enterprise deposits at the beginning of the year, grew by almost 32 percent in that year. This was probably in response to two things: the postponement of investment projects during the "retrenchment programi," resulting in a temporary increase in demand for financial assets; and the abolition of punitively low interest rates on such deposits. Although enterprises were not eligible for indexed deposits, they received the same interest rates as individuals with effect from September 1988. 8/ By the end of 1990, enterprise deposits were 36.2 percent higher than at the end of 1988, while nominal GDP was up 24.5 percent, and if the com- parison is made on the basis of 1987, such deposits are still below "nor- mal." Therefore, a good proportion of the growth in such deposits in 1990 can be attributed to enterprises restoring balances to a normal level.  Percentage Growth Rate 50 40 -/ 30 0+\/ ,= 20 i->W< 10 \e,,- 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1988 I 1989 I 1990 I 1991 Ml i3 Broad Money