China - Rural finance : a sector study

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 3864-CHA CHINA RURAL FINANCE: A SECTOR STUDY August 31, 1982 Agricultural Projects Division 3 China Programs Division East Asia and Pacific Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   FOR OFFICIAL USE ONLY CONFIDENTIAL ABBREVIATIONS AND ACRONYMS ABC Agricultural Bank of China BBC British Broadcasting Corporation, Summary of World Broadcasts BOC Bank of China BJR Beijing Review CBE Commune and Brigade Enterprise CBR China Business Review CR Cultural Revolution CITIC China International Trust and Investment Commission FBIS Foreign Broadcast Information Service FICC Foreign Investment Control Commission GAFX General Administration of Foreign Exchange Control IACE Integrated Agro-Industrial Commercial Enterprise JPRS Joint Publications Research Service JJGL Jingji Guanli (Economic Management) JJYJ Jingji Yanjiu (Economic Research) MOF Ministry of Finance NCNA New China News Agency NFSMC National Federation of Supply and Marketing Cooperatives NYJJWT Nongye Jingji Wefiti (Problems of Agricultural Economics) PBC People's Bank of China PCBC People's Construction Bank of China PICC People's Insurance Company of China RCCs Rural Credit Cooperatives RMRB Renmin Ribao (People's Daily) SCCC State Capital Construction Commission ZGBN Zhongguo Baike Nainjin ZGNK Zhongguo Nongken (Chinese Land Reclamation) ZGJR Zhongguo Jinrong (Chinese Banking and Finance) This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   CHINA RURAL FINANCE: A SECTOR STUDY Table of Contents Page No. SUMMARY AND CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . i-xi 1. AN OVERVIEW OF THE FINANCIAL SYSTEM . . . . . . . . . . . . . 1 A. Background .... . . . . . . . . . . . . . . . . . . . . 2 B. Principal Financial Institutions . . . . . . . . . . . . . 3 The People's Bank of China . . . . . . . . . . . . . . . 5 The People's Construction Bank of China . . . . . . . . 6 The Agricultural Bank of China . . . . . . . . . . . . . 7 Ministry of Finance. 7 C. Recent Banking Reforms and Rural Finance . . . . . . . . . 8 2. RESOURCE MOBILIZATION AND ALLOCATION IN RURAL AREAS . . . . . 10 A. Resource Mobilization ... . . . ..... . . . . . . . 10 Fiscal Resources .... . . . . ..... . . . . . . . 11 Household Savings .... . . . . . . . . . . . . . . . 13 Other Rural Resources ... . . . ..... . . . . . . 13 B. Financing of Agriculture ... . . . ..... . . . . . . 14 Central and Local Government . . . . . . . . . . . . . . 15 State Farms .... . . . . ..... . . . . . . . . . 19 Collective Production Teams . . . . . . . . . . . . . . 20 Other Collective Units ..22 Households and Private Plots ..23 C. Financing of Commune and Brigade Enterprises . . . . . . . 24 D. Financing of Rural Commerce. . . . . . . . . . . . . . . . 28 E. Financing of Other Rural Activities . . . . . . . . . . . 29 Roads ..29 Education . . . . . . . . . . . . . . . . . . . . . . . 31 Health . .32 F. Mobilization and Allocation: An Overview . . . . . . 33 3. THE AGRICULTURAL BANK OF CHINA ... . . . . . . . . . . . . . 34 A. Background . . ..... . . . . . . . . . 34 B. Objectives and Organnization . . . . . . . . . . . . . . . 34 C. Staffing and Training Programs . . . . . . . . . . . . . . 37 D. Credit Operations .... . . . ...... . . . . . . . 38 E. Financial Resources ... . . . . ..... . . . . . . . 39 F. Financial Results .... . . . ...... . . . . . . . 40 G. A Look at Provincial Operations . . . . . . . . . . . . . 41  Page No. H. Interest Rates . . . . . . . . . . . . . . . . . . . . . . 41 Lending Rates . . . . . . . . . . . . . . . . . . . . . 41 Deposit Rates .................... . 42 I. Appraisal and Supervision of ABC Subloans. . . . . . . . . 43 J. Accounting Systems and Auditing . . . . . . . . . . . . . 45 K. Rural Credit Cooperatives ..... . . . .. ..... . 46 L. Autonomy of RCCs and the ABC . . . . . . . . . . . . . . 46 4. COMMUNE AND BRIGADE ENTERPRISES . . . . . . . . . . . . . . . 48 A. Chronology of Development . . ............ . . . 48 B. Administrative Support and Control . . . . . . . . . . . . 51 C. Orientation of CBE Development . . . . . . . . . . . . . . 53 D. Recent Developments and Current Policy . . . . . . . . . . 54 E. Problems and Prospects for CBE Development . . . . . . . . 58 5. ISSUES IN DEVELOPMENT OF THE RURAL FINANCIAL SYSTEM . . . . . 64 A. Future Capital and Financing Requirements . . . . . . . . 64 B. Sources of Finance . . . . . . . . . . . . . . . . . . . . 66 C. Economic Reform and The Autonomy of Rural Financial Institutions . . . . . . . . . . . . . . . . . . . . . . 67 D. Organization and Management of the ABC . . . . . . . . . . 69 Relationship of ABC to Other Institutions . . . . . . . 69 Decentralized Credit Management . . . . . . . . . . . . 70 The Local ABC and the Production Responsibility Systems . . . . . . . . . . . . . . . . . . . . . . . 71 Credit Discipline ...... . .......... 71 Methods of Project Appraisal . . . . . . . . . . . . . . 72 Financial analysis . . . . . . . . . . . . . . . . . 72 Economic analysis ..... . ........ 73 Information Flows, Technology and CBE Development . . . 76 E. Interest Rates and Prices . . . . . . . . . . . . . . . . 77 Deposit Rates ....... . .......... 77 Lending Rates ....... . .......... 78 F. The ABC and External Assistance . . . . . . . . . . . . . 80 FIGURES IN TEXT 1.1 Organizational Structure of China's Financial System . . . . 4 3.1 Organization Chart of the Agricultural Bank of China at Central, Provincial and Local Levels . . . . . . . . . . . 36 4.1 Relative Importance of CBEs by Number of Enterprises, Employment and Income, 1980 . . . . . . . . . . . . . . . . 50  - iii - Page No. TABLES IN TEXT 2.1 Savings and Taxes in Rural Areas, 1977-80 . . . . . . . . . . 13 2.2 Estimates of Investment Expenditures in Agriculture, 1979 . . 16 2.3 Estimates of Operating Expenditures in Agriculture, 1979. . . 17 2.4 Breakdown of State Budget Expenditures in Agriculture, 1965-80. . . . . . . . . . . . 18 2.5 Investment in the Heilongjiang State Farm System, 1979-81 19 2.6 State Farm Profits and Losses, 1978-80. . . . . . . . . . . . 20 2.7 Estimates of Investment and Operating Expenditures in Commune and Brigade Enterprises, 1979 . . . . . . . . . . . 27 2.8 Highway Finances, 1979. . . . . . . . . . . . . . . . . . . 30 2.9 Expenditures in Formal and Nonformal Education, 1979 . . . . 31 3.1 Interest Rates and Increases in the Rural Price Level . . . . 42 4.1 Industrial Enterprises at the Commune, Brigade and Team Levels, 1979 ....51 4.2 Ranking of Growth Rates in Industrial Output of CBEs by Province, 1979-80 . . . . . . . . . . . . . . . . . . . 60 ANNEXE S ANNEX A State Council Circular on the Restoration of the Agricultural Bank of China (February 23, 1979). . . . . . 82 ANNEX B Credit Needs in the North China Plain. A Case Study of Production Teams in Northwestern Shandong, Northern Anhui and Eastern Hunan . . . . . . . . . . . . 86 ANNEX C Principal Persons Met and Places Visited by the Rural Credit Mission, November 2-21, 1981 . . . . . . . . . . . 97 ANNEX D Table Number: 1.1 Deposits and Loans of the State Banking System . . . . . . 100 2.1 State Budget Revenues 1950-80 . . . . . . . . . . . . . . . 101 2.2 State Budget Expenditures 1950-80 . . . . . . . . . . . . . 102 2.3 Source of Financing of Capital Construction Investment, 1950-81 . . . . . . . . . . . . . . . . . . . . . . . . . 103 2.4 Rural Savings Deposits by Commune Members 1976-80 . . . . . 104 2.5 Average Per Capita Rural Savings Deposits by Commune Members by Province 1980 ................. . 105  - iv - Page No. 3.1 Consolidated Balance Sheet of the Agricultural Bank of China, December 13, 1980 and June 30, 1981 . . . . . . . . 106 3.2 Consolidated Income Statement of the Agricultural Bank of China, 1980 . . . . . . . . . . . . . . . . . . . . 107 3.3 Statistics on Personnel and Organization of the Agricultural Bank of China, 1980 . . . . . . . . . . . . . 108 3.4 Balance Sheet of the Guangxi Branch of the ABC, December 31, 1980 and June 30, 1981. . . . . . . . . . 109 3.5 Income Statement of the Guangxi Branch of the ABC, 1980 . 110 3.6 Balance Sheet of the Shandong Branch of the ABC, December 31, 1980 and June 30, 1981 . . . . . . . . . . .111 3.7 Income Statement of the Shandong Branch of the ABC, 1980 . 112 3.8 Balance Sheet of the Zhejiang Branch of the ABC, December 31, 1980 and June 30, 1981 . . . . . . . . . . . 113 3.9 Income Statement of the Zheziang Branch of the ABC, 1980 . 114 3.10 Historical Trend of Interest Rates on Various Loans. . . 115 3.11 Interest Rates on Loans to Agriculture, Industry and Commerce . . . . . . . . . . . . . . . . . . . . . . . 116 3.12 Interest Rates on Individuals' Bank Deposits . . . . . . 117 3.13 Deposits and Loans of Rural Credit Cooperatives. . . . . . . 118 4.1 Development of Commune and Brigade Enterprises, 1958-80. . . 119 4.2 Types of Commune and Brigade Enterprises . . . . . . . . . . 120 4.3 Characteristics of Commune and Brigade Enterprises by Province, 1979 . . . . . . . . . . . . . . . . . . . . . . 121 4.4 Ranking of Provincial Level Units by Industrial Output from CBEs, 1980. . . . . . . . . . . . . . . . . . . . . . 122 4.5 Aspects of CBE Development in Three Provinces, 1980 . . . . 123 ANNEX E Figure Number: 4.1 County-Level Economic Administrative Structure, Xinhui, Guangdong . . . . . . . . . . . . . . . . . . . . . . . . 124  SUMMARY AND CONCLUSIONS An Overview of the Financial System 1. The major objective of this study is to provide a better under- standing of China's rural financial system and of those factors which are likely to influence its effectiveness in the years ahead. The country's financial system includes several national level organizations under two administrative jurisdictions operating under the general guidance of the State Council: the People's Bank of China (PBC) and the Ministry of Finance (MOF). The PBC is China's most comprehensive banking institution with some functions similar to those of a central bank in market economies. It is the only organization allowed to issue currency and is responsible for implementing national and regional cash and credit plans. As the center for cash, credit and settlements transactions, it is in theory able to monitor plan fulfill- ment, efficacy of state financial management and other financial activities of the basic-level units in the economy. The MOF is the national fiscal institution and has the responsibility for compiling the central government's annual budget and long-term financial plans. It supervises the financial work of other ministries and state organs, reviews local government budgets, collects government revenues and makes all budgetary disbursements, most of which are channeled through the PBC, People's Construction Bank of China (PCBC) or the Agricultural Bank of China (ABC). The MOF has a strong influence over China's banks through a relationship which is generally complementary. However, jurisdictional overlap between functions of the MOF and PBC may remain in some areas such as authority over loans for investment and financing of working capital. Coordination of these activities is the responsibility of the State Planning Commission 2. The People's Construction Bank is largely a channel for capital construction funds appropriated in the state budget, but it also makes loans for specialized construction enterprises and is responsible for the settling of accounts in China's capital construction system. It is in charge of implementing the recent policy of converting capital construction appro- priations from grants to interest-bearing loans. The Agricultural Bank is the recently-restored institution responsible for unified management of all state financial appropriations for rural areas, except funds for state-budgeted capital construction in agriculture, forestry and hydroelectricity. Other key actors on the financial stage include the Bank of China, which is in charge of foreign exchange transactions, the General Administration of Foreign Exchange Control, which formulates and oversees foreign exchange regulations, the State Capital Construction Commission, which coordinates capital construction expenditures and the China International Trust and Investment Corporation, which facilitates joint ventures with foreign capital. This network is relatively new, with the present arrangement dating only from 1979. Moreover further changes are now being made as a result of the major governmental reorganization of March 1982.  - ii - 3. Recent reforms of China's financial system are aimed at increasing the efficiency with which financial resources are used. Major elements of these reforms include reassertion of the independence and integrity of the banking system, greater use of economic criteria in evaluating loan proposals, decentralizing decision making in credit allocation, improving the human capital in the banking system through training activities, and increased intermediation by local banking units, including lending for projects which may not be part of the state plan. Resource Mobilization and Allocation in Rural Areas 4. Financing of rural development has been based to a large extent on self-reliance and the mobilization of local resources by producing units. Although 30% of GDP flows through the state budget, revenues collected or spent in rural areas equal only a small portion of rural incomes or total budgetary revenues. Budget revenues originate primarily from taxes and profits of state enterprises. The agricultural tax and taxes on commune and brigade enterprises are the major rural sources of revenues for state coffers, although these together account for no more than about 5% of total budgetary revenues. Extra budgetary funds, which originate from profits, taxes and fees on certain state and collective enterprises and which accrue mainly to local governments and local bureaus, have grown very rapidly in recent years. But, again, very few of these revenues are collected or spent in rural areas. Rural savings and individual deposits in rural banks have increased sharply since 1977, reflecting higher procurement prices and increased production, higher deposit rates paid by financial institutions, improved banking services in rural areas and shortages of some high quality consumer goods. Deposits of private individuals in 1981 accounted for more than 40% of total deposits with the rural credit cooperatives. But despite this rapid growth in individual savings, the major determinants of the volume of resources made available for rural investment are decisions by collective units (communes, brigades, teams) as to the allocation of their income between consumption and investment. Government guidelines are that 5-7% of the net income of collective units should be set aside for investment ("accumulation funds"). But poorer units face difficulties in achieving even these modest levels and therefore find it impossible, without supplementary funding, to break out of low-productivity agriculture or expand into profitable CBE development. 5. Responsibility for investment and production in agriculture is divided among a number of different institutions, including central and local governments, state farms, collective units and individual households. Recent government efforts to improve the efficiency of the financial system have been focused largely at the lower levels of this structure - through introduction of the production responsibility system on state farms and collective units, through an expanded role for private plot agriculture  - iii - and by permitting larger roles for local bank units in the mobilization and use of local funds. Rough estimates for 1979 suggest that more than 60% of total operating and investment expenditure in agriculture came from retained earnings of production units and households, while about 30% was provided through bank loans. The balance came from the state budget and extra-budgetary funds. Although relatively small, state budget - financed investment by central and local governments are particularly important in large-scale land development and water conservancy projects. The government also provides important support to agriculture through funding of, e.g., research and higher-level agricultural education. State budget expenditures on agriculture are divided into allocations for capital construction - now about 40% of the total and declining - and support to agriculture, including financial aid to production units in poorer areas. 6. Investment in the state farm sector (which accounts for less than 5% of the country's arable land) has been financed largely through state budget grants. With the recent emphasis on improving the efficiency of this sector, bank loans and retained earnings are being emphasized as increasingly important sources of production and investment finance. This shift in sources of finance is made possible by the improved financial performance of state farms -- after a long period of annual losses, the state farm sector as a whole reported profits in 1979 and 1980. 7. The collective system accounts for about 60% of agriculture's capital expenditures and up to 90% of its annual expenditure on production inputs. At the level of the production team, the major investment is labor by team members for land development and water conservancy works. In recent years, financial investment in farm machinery (pumps, engines, hand tractors, etc.) appears to have become more important. Extension of the production responsibility system is shifting a larger share of production expenditures from the team to the household or production group and is resulting in some cutback in financial outlays for large machine services or production inputs deemed uneconomic. Although own funds continue to be the most important source of financing production expenses by teams, use of bank credit is increasing. Financing of investment by brigades and communes in small-scale water conservancy works has come largely from accumulation funds and labor contributions of teams. Surveys suggest that inadequate funds to purchase e.g. pumps, engines and well-construction services, is one factor constraining development in high weather-risk areas such as the North China Plain. 8. Production teams are now allowed to set aside up to 15% of cultivated land as private plots on which families may produce the crops or animal products of their choice. Private plots contribute up to 30% of total household income and household expenditure on private plots may account for as much as 20% of total capital expenditures in agriculture. Until recently, finance for private plot agriculture came largely from household savings. Loans to households from rural credit cooperatives  - iv - (RCCs) are growing rapidly (Y 1.1 billion at end 1979 to Y 2.9 billion as of the third quarter, 1981) and may now account for about one-quarter of total RCC loans outstanding. In the period January-August 1981, lending to individuals tripled when compared with the same period of 1980. 9. Commune and brigade enterprises (CBEs) employ about 10% of the rural labor force and account for one-third of incomes and assets of communes, brigades and teams. Their rapid growth in recent years reflects a favorable price regime (relatively low-cost raw materials, high prices for finished products) and tax and other incentives. Demand for CBE investment funds has grown apace and has been met from a variety of sources, including, in estimated order of importance, retained earnings, bank loans, contributions of labor by team members, and state budget allocations. Some experiments in CBE funding using sales of stocks and bonds have also taken place. At the end of 1980, ABC loans to CBEs totalled Y 4.8 billion, or some 10% of ABC's loan portfolio. 10. The financing of rural commerce, particularly the activities of the National Federation of Supply and Marketing Cooperatives (NFSMC) and commercial departments of the Ministries of Food and Commerce, have made large demands on the rural financial system. Most of this is working capital to finance inventories, some of which reportedly exceed normal requirements. At the end of 1980 loans to rural commercial enterprises accounted for about two-thirds of ABC's loan portfolio. Financing for other rural activities is provided from a number of sources, including budgetary allocations and collective and individual contributions. The burden of financing road consLruction has been shifted to provincial, county and commune organizations. Road maintenance is the responsibility of local governments and necessary resources for this purpose derive from a road maintenance tax, commune funds, and team labor. While higher level education is largely the responsibility of the central government, the funding for middle, primary and vocational education is provided by provincial and local governments, collectives and individuals. Middle-level schools in the communes are operated by the county, but communes may help to meet costs of providing teachers. Capital construction and operating expenditures for schools are financed largely from the state budget, although primary schools may be built through brigade self-help schemes. The three-tiered rural health system - hospitals at the county level, health centers in communes, and health stations at brigades - is funded from budgetary allocations, brigade welfare funds, individual user fees and voluntary labor for construction.  v Agricultural Bank of China 11. Following several short-lived efforts to establish an agricultural bank in the 1950s and 1960s, the State Council in 1979 ordered the restoration of the ABC and made it responsible for the "unified manage- ment" of all state financial appropriations for rural areas, with the exception of funds budgetted for capital construction in agriculture, forestry and hydroelectricity, which continue to be handled by the PCBC. The re-established ABC consists essentially of the staff, offices and other physical facilities of the PBC's former Agricultural Finance Department. In addition to its tasks of channeling public funds to rural areas and extending credit, the ABC provides a wide range of banking services to rural areas, serves as PBC's agent in these areas, supplies leadership to the RCCs and provides financial guidance to collective units. The ABC has 27 branch offices in provincial capitals, more than 2,200 subbranches at county level, and some 25,000 offices in communes and state farms. In addition, some 59,000 RCC offices operate at commune and brigade level. With an ABC staff of 285,000, together with 250,000 part- or full-time RCC staff, this network of personnel and offices means that virtually all of China's 53,000 communes and 2,000 state farms have relatively good access to institutional credit. By virtue of ABC's antecedents, most staff of the ABC have considerable experience in rural credit and finance, although the number of university graduates is small, probably less than 5% of total establishment. 12. ABC's total loan portfolio as of December 1980 was Y 47.6 billion. At that time, the ABC had on-l'ent to commercial departments of, e.g., Ministries of Food and Commerce, another Y 18.5 billion of PBC funds for the purchase and marketing of agricultural products. About 80% of ABC's loan portfolio consists of short-term loans of less than one year while 20% is in loans of up to 5 years' maturity. More than half of ABC's portfolio consists of working capital to finance rural commerce, particularly the National Federation of Supply and Marketing Cooperatives (NFSMC). Another 30% of ABC's loans went to communes, brigades and teams, including 10% to CBEs and nearly 20% for agricultural purposes. For most of its (net) resources in 1980 of Y 55.3 billion, the ABC relied on state capital grants (Y 20 billion) and deposits, the major ones being those of RCCs (Y 21.1 bil- lion), state-owned agricultural enterprises (Y 3.7 billion), rural commer- cial enterprises (Y 3.0 billion), deposits of individuals (Y 2.8 billion) and other government agencies (Y 2.4 billion). Savings deposits are liquid and fixed-term; the latter range from 6-months to 8-years' maturity. 13. In its first full year of operation (1980), the ABC reported a profit of Y 362 million. Revenue were derived from interest earnings (Y 1.46 billion), agency fees (Y 695 million) and government grants to compensate for the negative spread between lending rates and (higher) deposit rates (Y 170 million). Administration costs of less than 2% of  - vi - total resources employed is low by international standards, and reflect generally low salaries. Little information is available on the quality of ABC's loan portfolio. Overdues may exceed 25% of loans outstanding in some areas. After periods of laxity in enforcing credit discipline, the ABC now stresses timely repayment and seems to be making some progress in reducing overdues. The ABC estimates that bad debts currently are less than 1% of loans outstanding; adequate allowance for bad debts may not have been provided in the consolidated accounts. In the past some overdues have been written off, but most have been rolled over. 14. During the 1960s and early 1970s interest rates charged on ABC loans were reduced in parallel with reductions in deposit rates. In 1976-81 lending rates were increased but more slowly than deposit rates, resulting in a negative interest rate spread. A substantial upward adjustment in lending rates in early 1982 eliminated some of the negative spreads. Deposit rates have been increased in the last three years and the range of savings instruments has been extended to include time deposits of up to eight years' duration. Although real interest rates were negative during 1979 and 1980 (when inflation was high relative to China's previous record of remarkable price stability), recent declines in the inflation rate appear to have again resulted in positive real rates on both demand and time deposits. 15. ABC evaluation of subloans involves assessment before the loan is granted, supervision during disbursement and post-disbursement review of project impact. At present the most important factors influencing the decision to finance a project appear to be its conformity to the state plan and availability of materials and markets. Recent policy decisions are expected to give ABC somewhat more autonomy, although lending emphasis must be consistent with state plans. Appraisal of subloans by ABC emphasizes cash flow and material balances. No formal financial or economic analysis using discounting techniques is used, although pay-back periods are sometimes calculated. In addition to extending credit for investment projects, the ABC often acts as an intermediary to help locate raw materials needed for implementation and markets for project output. Frequently, it also requires a formal contract which stipulates rights and obligations of the ABC, the borrowing unit and suppliers of the equipment or materials to be financed. 16. ABC has a large number of accounting and statistical staff who prepare timely, consistent and detailed records which are supplied to higher level units on a regular basis. One apparent weakness is lack of detailed information on overdues. The accounts of ABC headquarters are examined by the Ministry of Finance, although this may not involve comprehensive auditing. ABC's internal auditing appears to be even more cursory, but plans are to strengthen this function in line with new national policy emphasis on financial accountability within the banking system. 17. The rural credit cooperatives, while collectively-owned financial units, serve as the basic level units of the ABC. Their sources of funds  - vii - include deposits of individuals, deposits of collective units and, occasionally, loans from the ABC. Uses of funds includes loans to indivi- duals, to collective agricultural endeavors and to CBEs. RCC deposits at the end of 1980 totalled Y 29.2 billion while loans equalled Y 8.2 bil- lion. In general, RCCs are net suppliers of funds to ABC. The RCC loan portfolio has doubled between the end of 1979 and the end of 1981 - largely reflecting sharp increases in loans to CBEs and individuals. By the third quarter of 1981, RCC loans to individuals were nearly half as large in total volume as all agricultural loans to communes and brigades. Although the RCCs operate under the guidance of the ABC, their degree of autonomy varies from place to place. In some locales the ABC may emphasize agricultural loans to collective units or loans to CBEs while the RCCs are responsible primarily for loans to individuals. With local level operations virtually identical, the rationale for maintaining the local ABC and RCCs as distinct organizational entities is not always clear. Commune and Brigade Enterprises 18. The term "commune and brigade enterprises" (CBEs) refers to the more than 1.4 million enterprises in industry and mining, agriculture and the service trades that are collectively-owned by communes, production brigades and, occasionally, production teams. They are typically small-scale, often seasonal in nature, and in the past have frequently employed relatively simple machinery to produce for a local market. But variations among CBEs in terms of size, type of production and level of technology are enormous. CBE output has grown by more than 18% annually in recent years. In 1980 gross revenues ("output value") totalled Y 68 billion and the Y 11.9 billion in wage payments averaged Y 15 per capita in the countryside. This was equal to 18% of the per capita income distributed by the collective sector. 19. A key principle behind CBE development in the past was that CBEs were to use locally-available raw materials to meet local needs, while prime factors of production were reserved for use by the modern, state-owned industrial sector. To enforce this principle, a support and control mechanism has been established with four offices at the county level - the planning committee, offices of finance and trade, agriculture, and industry and transport - playing important roles. Within the office of industry and transport, the key agency is the county bureau for CBE development which has the responsibility to recommend approval (or disapproval) of new enterprises, based on guidelines set by provincial or prefectural offices. For project investments of less than Y 10,000, the county planning office makes the final decision; for larger projects, approval must come from the prefectural planning commission. 20. Poor planning and hasty development of CBEs in the 1960s and early 1970s resulted in some duplication of facilities and establishment of enterprises which frequently were technologically inefficient and financially weak. A process of rectification and economic adjustment has been underway in recent years. Tax concessions granted in 1978 have been  - viii - rescinded for enterprises which face marketing difficulties or compete for raw materials with state-owned industry. The State Council in mid-1981 directed that communes refrain from establishing large textile mills, cigarette factories and other enterprises which were considered to be better handled by state enterprises. Inefficient CBEs are to be closed down and provinces are to examine CBE investment proposals more carefully to ensure that the approved new capacity will have adequate raw material supplies and market outlets. Whenever possible, CBEs are to be included in state plans; at present, only about 20% of CBE output is part of the state plan. China's price structure and system of local taxation, with revenues going to local governments, has contributed to the proliferation of small scale, frequently technologically inefficient CBEs. 21. Among the factors which are likely to influence future development of CBEs are their geographical concentration, discrimination against collective enterprises in the allocation of materials and equipment and inadequate guidance and support from industrial ministries and transport, supply and marketing departments. Among the 29 provinces, autonomous regions and municipalities, 55% of CBE income originates in three municipalities and four provinces, while less than 3% of production is accounted for by the lowest eight provinces. Discrimination against collective enterprises in the allocation of materials, marketing difficul- ties and inadequate support from industrial ministries and commercial departments reflect the fact that most of the CBEs are poorly articulated within the formal planning network. Price reform which would ease supply bottlenecks and policies permitting easier access by CBEs to local and external markets may be as effective in assisting future CBE development as more formal incorporation into the state plan. Issues in Development of the Rural Financial System 22. Although current economic policy is aimed at reducing investment shares and increasing consumption in national income, continued growth of rural investment and more efficient use of investment funds are recognized as necessary to modernize agriculture and improve rural living standards. Two of the greatest challenges for China's rural sector will be to supply the food and raw materials required by population and income growth and to provide employment opportunities for an expanding labor force. Agricultural development programs for the 1980s are expected to lead to increased intensification and diversification, with significant implications for the rural financial system. In the state farm sector, annual investment in the Sixth Plan period (1981-85) is expected to rise from Y 1.1 billion in 1980 to Y 1.4 billion. In the collective sector, recent reforms have opened new opportunities for livestock, food and cash crop production. There are also opportunities for improved water control. The rapid expansion of the production responsibility system and extension of private plot agriculture is already reducing the demand for large equipment and increasing the demand for hand tools and smaller-scale machinery, as investment decisions are  - ix - shifted from teams and brigades to households. Increased commercialization of agriculture will add to the financing requirements in rural commerce and transport. With the likelihood that employment creation in rural areas will become a more important policy objective, emphasis on CBE development will increase. Examples of suitable CBEs might include textile plants based on local raw materials, garment industries, food processing and other consumer and rural producer goods industries. In the more highly developed areas near urban or export markets, the growing integration between CBEs and state enterprises is likely to create strong new demands for finance. In the poorer areas, bank credit or state budgetary support are likely to be required to permit collective units to modernize agriculture or engage in profitable CBE development. 23. These developments in agriculture, rural commerce and industry will make new demands on the rural financial system. This is recognized in the Government's efforts to strengthen the role of the banks in mobilizing and allocating resources in rural areas. Price reform and banking reform should proceed together in order that the greater autonomy of banks will result in investment activities based on prices which reflect economic values and costs. The autonomy of banks needs to be considered in relation to available mechanisms for managing the overall level of economic activity and controlling inflation. More should be known of the impact of price reform on the viability of ABC's lending program. The policy of replacing budgetary grants with bank loans is to be welcomed as a means to enhance efficiency in use of those resources. More consideration might be given to the types of institutions and expenditures that would benefit from a judicious mixture of grants and credits. Finally, it is important that increased autonomy given to banks be accompanied by greater financial independence for borrowing units to ensure that they are influenced by profit and loss considerations. 24. More specific issues relate to the organization and management of the ABC. The ABC still carries out a substantial volume of business on behalf of the PBC. It would seem useful to compare this system with an approach which incorporates the PBC-related work into the regular operations of the ABC. The PCBC also operates in rural areas as the disburser of state budget funds for capital construction and in occasional loans to state farms and to CBEs. The interest rate structure on these loans appears to differ from that at the ABC. There may also be some overlap between ABC and RCCs, although coordination among these units appears to be good. It should be determined whether excessive or wasteful duplication exists among these various financial agencies. 25. Extension of the production responsibility system is likely to add significantly to the demand for credit and banking services at the household level. Changes in the pattern of ABC and RCC lending are already underway: loans to individuals are growing rapidly; these loan funds are being increasingly used for production purposes; and short- and medium-term  x loans for tools and small equipment are growing more rapidly than loans for large equipment. Local offices of ABC and RCCs are having to work with more customers and respond to a wider range of loan requests. It seems necessary to expand the work of RCC branches below commune level and establish more credit operations at brigade and, perhaps, at production team level. 26. Strong credit discipline should continue to be an important principle in ABC operations. There is need to examine reasons for overdues in China's rural lending program and devise means to keep these under strict control. Contributing factors may have been natural disasters, lending for unsound projects which do not have adequate debt service capacity and the financing of medium-term investments with short-term loans. The recent policy decision to allow the banking system to impose penalty interest rates on overdue loans should be adopted on a universal basis. An improved reporting system also is required which permits ABC to determine its arrears position accurately and quickly. 27. Perhaps the weakest area in ABC's operations is its approach to appraisal of investment proposals. The focus on cash and materials balances, while essential to sound planning, gives inadequate attention to financial analysis. Almost no consideration is given to economic analysis in formulating lending policies, a particularly serious shortcoming in an environment where differences between financial and economic prices are sometimes wide. A valuable first step in improving appraisal methodology would be for ABC to develop a simple project appraisal handbook which provides a checklist of issues to be examined during project identification and preparation. A major thrust of the handbook should be to explain how financial and economic benefits and costs of different types of projects are to be evaluated and compared. A second priority requirement is to develop a program for the training of project staff in project analysis. In view of the large numbers of ABC and RCC staff which require familiarization with improved appraisal techniques, careful consideration is required on how to make the training effort most cost effective. 28. Apart from the provision of credit, the ABC can contribute to rural development through its role as a supplier of information on raw material availability, market outlets and improved technology in ABC-financed projects. This role is particularly important in furthering CBE development in more isolated areas where contact with the modern sector is more limited. In some of these areas, the availability of financial resources may be a less binding constraint on CBE development than lack of information on raw materials, markets and suitable technology. Establishment of a technology dissemination unit within the ABC might be appropriate in view of its extensive network of contacts among potential users of these services in the collective units.  - xi - 29. The level and structure of deposit rates and lending rates are likely to be important factors in shaping China's rural financial system. As increased emphasis is given to mobilization of savings for investment, the level of real interest rates can be expected to play a more decisive role than in the past. At the minimum, real interest rates on time deposits should remain positive. The recent action to increase lending rates relatively more than deposit rates will strengthen ABC's financial performance. Lending rates should exceed deposit rates by a margin sufficient to cover administrative costs and provide some profit as an incentive to increase lending. Higher interest rates on ABC loans will also enhance the efficiency with which major borrowers such as the NFSMC use those resources. Equally important is the new authority of banks to levy penalty interest on overdue loans, on loans for excessive working capital and inventories and on loans diverted from working capital to unsanctioned uses. Full use of this set of economic levers would be a valuable part of ABC's efforts to improve rural financial management. 30. The role of external assistance in China's rural credit system will be mainly catalytic, in view of the small amounts of external funding likely to be involved relative to annual loan volumes by the ABC and RCCs. But if carefully designed, this assistance could be useful in helping to strengthen the system and improve rural financial management. Particular attention would need to be paid to the lending emphasis (e.g., geographic, commodity, agro-industry) and to the financial and economic criteria that would be used in the evaluation of subprojects. The World Bank's knowledge of possible rural lending opportunities in China remains limited, but probably can be enhanced most effectively through project identification and preparation work. Proceeds of a possible World Bank loan might be used in at least three ways: to augment the loan funds of the ABC and RCCs; to finance office equipment and computer facilities for ABC operations; and to support the training of higher-level ABC managerial and technical staff in short-term and degree programs in China and abroad. Assistance in strengthening ABC's institutional capabilities is ultimately likely to be as valuable as the financial resources which are provided.   CHINA RURAL FINANCE: A SECTOR STUDY /1 1. AN OVERVIEW OF THE FINANCIAL SYSTEM 1.01 The World Bank's economic report on China /2 described briefly the rural credit system and outlined the working of one of its principal institutions, the Agricultural Bank of China (ABC). It noted the Government's intent to expand the flow of credit to rural areas as part of the general thrust of recent economic reforms and readjustments. The report also suggested that the ABC, by virtue of its extensive network of local offices linked to state farms and collective production units, may merit some priority as a channel for larger financial flows to Chinese agriculture. This study examines in greater detail the operation of China's rural financial system and, in particular the ABC and the rapidly-growing enterprises under commune and brigade management. The major objective of the exercise is to provide a clearer understanding of the workings of the system and of those factors which are likely to influence its effectiveness in the years ahead. 1.02 This report is limited in detail and scope. The World Bank is at an early stage in its understanding of China's rural financial institutions. The financial system is very large in terms of the volume of its annual financial flows and complex in terms of the number of collective, state and private decision-making groups which influence its operations and use its services. Description and analysis of the system also is complicated by the rapid changes in economic policies in China today and the necessity of key institutions, such as the ABC, to change as a result. Although built upon a long history, the ABC in its present form is a new institution and its policies continue to evolve. Wide variations in its operational policies among provinces further complicate the task of describing in general terms /1 Based on a World Bank Rural Credit Mission to China in October-November 1981, including Messrs. J. Goering (Leader), B. Argyle (Rural Credit Specialist), I. Porter (Economist), all of the Bank, and Ms. C. Wong (Specialist on Commune and Brigade Enterprise), consultant. The mission held discussions with staff of the Agricultural Bank of China in Beijing and travelled to Shandong and Zhejiang Provinces and Guangxi Autonomous Region. Revisions of the Green Cover version of this report were made on the basis of discussions held with the Government in Beijing in April 1982. /2 China: Socialist Economic Development, June 1, 1981, Report No. 3391-CHA.  - 2 - the workings of the ABC. While new ground has been broken in furthering the World Bank's understanding of China's rural financial system, further detailed analysis is required to provide a clear picture of the system which governs the flow of financial resources among some 800 million rural people. That analysis requires additional time and effort and, above all, the continued development of closer working relationships between the World Bank and China's rural financial institutions. A. Background 1.03 China's financial system has been a major factor in shaping the pattern of rural development in the past thirty years and has been called upon to assist in implementing a number of rural reforms since 1949. It played on active role in helping control the hyper-inflation prevailing in the late 1940s. After the private banking system was nationalized, or brought under the control of the People's Bank of China (PBC), the PBC promoted the socialization of industry and commerce by various means, including discrimination against private sector activity and inducements to firms to become joint state-private enterprises. The collectivization of agriculture also was heavily supported by loans from the banking system to the newly-established collective units. 1.04 After the 1950s, political goals became relatively less important in policies affecting the rural financial system, although ideological considerations lay behind several key policies such as periodic reductions in interest rates charged to rural borrowers. The banking system also has been called upon to promote development of specific sectors of the economy by means of special loans and/or particularly favorable interest rates. Agri- culture and rural-oriented activities were among the most favored sectors in terms of institutional credit programs. That policy has been retained. Even today funds for the purchase of agricultural equipment and construction of small hydroelectric facilities carry the lowest interest rates of any bank loans. These low rates are officially rationalized as essential to spur rural development and compensate rural producers for the disincentives of relatively low state procurement prices for key agricultural products. 1.05 An overview of China's rural financial system and its operations is provided below. A second section discusses the financing of agricultural and rural development in China, while a subsequent chapter looks at the operations of the ABC. Chapter 4 provides a description and analysis of commune and brigade enterprises. A concluding section considers some factors which are likely to influence future development of China's rural financial system.  -3- B. Principal Financial Institutions /1 1.06 China's financial system at present includes eight national level organizations under two distinct administrative jurisdictions: the People's Bank of China (PBC) and the Ministry of Finance (MOF)./2 The former is China's chief banking institution, an independent, ministry-level entity that reports directly to the State Council. The People's Insurance Company of China (PICC) has the status of a subordinate department of the PBC. The PBC also manages' on behalf of the State Council three nominally independent organizations: the Bank of China (BOC), in charge of foreign exchange transactions, the General Administration of Foreign Exchange Control (GAFX), responsible for formulating and overseeing foreign exchange regulations, and the Agricultural Bank of China (ABC), which handles most bank work in rural areas. The rural credit cooperatives, originally collective bodies formed voluntarily by local peasants, serve as the basic level units of ABC. 1.07 On the fiscal side the Ministry of Finance is the most important institution. Together with the State Capital Construction Commission (SCCC), it manages the People's Construction Bank of China (PCBC) which, like the BOC, ABC and GAFX, is in theory subordinate only to the State Council itself. The PCBC handles state budgeted capital construction appropriations whether loans or grants, and in addition provides banking services to capital construction teams and various related units. The China International Trust and Investment Corporation (CITIC) also has a position directly below the State Council. Its main functions involve arranging and facilitating joint ventures using Chinese and foreign capital as well as handling investments in China by foreign companies and overseas Chinese. All joint ventures, however, must be approved by the Foreign Investment Control Commission (FICC)./3 The institutional relationships among China's financial organi- zations are shown in Figure 1.1. 1.08 This organizational structure is only a few years old. During the Cultural Revolution, the PBC was incorporated in the MOF, and little was heard about or from it. The BOC was separated from the PBC only in March /1 In this and other sections the description of institutional arrangements refers to the situation that existed at the end of 1981; the changes that have resulted from the March 1982 governmental reorganization are not taken into account. /2 The general discussion that follows is based mainly on three sources: PBC, Planning Bureau (1980), pp. 2-4; China Business Review (CBR), July-August 1980, pp. 15-18; and Zhang Enhua, "On Banking Reform", BJR (29), 7/20/81. /3 "The Law of the People's Republic of China on Joint Ventures Using Chinese and Foreign Investment", Article 3; translated in BJR, No. 29, 7/20/79, p. 24.  -4- CHINA RURAL FINANCE: A SECTOR STUDY Figure 1.1 :- Organizational Structure of China's Financial Systeml/ The State Council W I ~~~~~~~~~~~~~~~~~~~~~* _S China Intentoa Stat Caia Miis P;;e;;ple's 1 Trust and Investment Construction of Sa'nk of Corporation Commi ssion . F inance .Ch ina People'st Administrto Bank Agricultua Insuranc R ural Credit Cooperatives Source: Adapted from Zhang Enhua, "On Banki,ng Reform", Beijing Review, No. 29, July 1981, p. 26. 1/ Dottad lines indicate responsibility on basic policy matters. World Bank -23566  -5- 1979; GAFX was created at the same time, CITIC somewhat later in the year. There were several attempts to set up an agricultural bank in the 1950s and 1960s, all short-lived. The present incarnation of the ABC dates from February 1979. The PCBC was made an independent entity in November 1979. The PICC resumed domestic insurance business at the beginning of 1980, after an interruption of over 21 years. Through most of the 1970s China's banking system was under the control of the MOF, and specialized banks either did not exist or were without independent status. The People's Bank of China 1.09 The PBC is China's most comprehensive banking institution. As an administrative organ for government financial management, and at the same time an economic entity managing loan activities, it has wide-ranging responsibilities. Despite some departures, the PBC approaches fairly closely in formal scope and authority the concept of a "monobank" - the nerve center and monitor of the economy at both the micro and macro levels. It serves many of the functions that in market economies are the responsi- bility of the central bank and performs services handled by commercial banks, savings banks and, more recently, investment banks. The PBC is the country's center of cash, credit and settlements transactions./1 By virtue of its monopoly position, it is in theory able to monitor the degree of plan fulfillment, efficacy of financial management, and other activities of the basic-level units in the economy. 1.10 The PBC is the only organization in China permitted to issue currency, and is responsible for devising and implementing national and regional plans for cash in circulation. With a few exceptions related to China's capital construction system, all state-owned enterprises and other government entities as well as Party Committees and mass organizations must keep their funds in an account at one and only one branch bank. Only very small payments can be made in currency, using strictly limited cash reserves that units are allowed to keep in their possession. All other transactions in the state sector of the economy must be consummated by appropriate credit- ing and debiting of the parties' bank accounts. Again with some notable exceptions in the rural credit and capital construction system, all loans of circulating funds (working capital) are supposed to emanate from the PBC. 1.11 The PBC holds savings accounts of individuals in urban areas and sets interest rates on all loans and deposits, subject to approval by the State Council. Except for state-budgeted capital construction funds, it /1 Zeng Kanglin and Yan Yi "The Present Financial and Banking System must be Reformed" RMRB, 10/6/80; translated in JPRS E.A. (103).  -6- handles revenue accruing to, and disbursements from, the national treasury. Foreign exchange rates are set by the PBC, which has overall responsibility for international activities, though the BOC manages day-to-day transactions. 1.12 As of the end of 1979 the PBC network included 29 provincial-level branch banks, 148 municipal-level subbranches (in cities directly subordi- nate to the provinces), 220 central subbranches in prefectures and 2,777 county-level subbranches. The PBC has a total of 330,000 employees, including only 1,200 at the head office in Beijing. The latter is divided into 14 departments including the headquarters of the PICC. PBC branches are under the "dual leadership" of the head office and local party committees. In professional work the leadership of Beijing is supposed to be primary, while in the realm of political work and Party affairs the localities play the dominant role. The PBC regained its independent status only after 1976. Since then it has been trying to repair past damages and expand its role as a flexible expediter of economic development. The People's Construction Bank of China 1.13 The PCBC is mainly a conduit for capital construction funds appro- priated in China's state budget. It also acts as a true bank in making cir- culating capital loans to, and handling the deposits of, specialized construction and installation enterprises, geological prospecting units, and enterprises which supply construction materials. The PCBC settles accounts in China's capital construction system. To carry out these functions it has 2,500 branches throughout China. In November 1979 the PCBC was made an independent organization on the national level directly subordinate to the State Council, managed on its behalf by the MOF and to a lesser extent by the State Capital Construction Commission. 1.14 The PCBC is in charge of implementing the recent policy to trans- form state capital construction appropriations from nonrepayable grants into interest-bearing loans. It handles all such loans, which at present can be made only to "independent accounting units" - mainly enterprises. Investment expenditures in the so-called "nonproductive" sector - government administra- tion, defense, scientific research, culture, education and public health will continue to be grants disbursed by the MOF through the PCBC. Many productive sectors such as heavy industry, which have losses or low profits, will continue to receive grants. Capital construction loans from PCBC carry the low interest rate of 3.6% per annum. Therefore, the main effect on enterprise decision-making will come from the fact that investment expenditures are now repayable with the proceeds of the projects concerned. This contrasts sharply with the past, when investment funds were free gifts for which units competed vigorously. Once funding was obtained there was little reason for them to economize in its utilization.  - 7 - 1.15 Capital construction loans were first introduced on an experi- mental basis in eight enterprises in August 1979. By the end of September 1980, a total of Y 3.2 billion in capital construction loans had been made to 626 different projects. During the 1960s and early 1970s the PCBC was at the forefront in making new innovations in Chinese banking practices. Though the PCBC loans of that period were relatively small in magnitude and still highly fiscal in character, they set a precedent for financing investment by means of credit rather than budgetary grants. The institution of capital construction loans most likely has enhanced the PCBC's decision-making role, since it now has the authority to approve or reject loan applications. The Agricultural Bank of China 1.16 The ABC is the recently restored specialized institution in charge of rural banking. It is also responsible for unified management of all state financial appropriations for the rural economy, with the exception of state-budgeted capital construction in agriculture, forestry and hydroelectricity, which continues to be handled by the PCBC. Though the ABC nominally answers directly to the State Council, the PBC is charged with managing the ABC on behalf of the Council. Operations of the ABC are discussed more fully in Chapter 3. Ministry of Finance 1.17 The MOF is China's national fiscal institution and has the task of compiling the central government's annual budgets and long-term financial plans. The MOF collects government revenues and makes all budgetary disbursements, most of which are channeled through the PBC, the PCBC or the ABC. The MOF supervises the financial work of other ministries and state organs as well as the operations of finance and taxation departments of local governments. It reviews and approves local government budgets before they are submitted to the State Council and then to the various People's Congresses for final ratification. It also formulates tax and budget regulations and oversees interprovincial fiscal transfers. 1.18 The MOF continues to have a strong influence over China's banks and there are areas where jurisdictions and activities overlap. Working capital funds for state enterprises are provided partly by means of budget appropriations in the form of permanent nonrepayable grants, partly by bank loans. In most respects these are close substitutes from the viewpoint of recipients. Short and medium-term loans for equipment similarly are close substitutes for "tapping potential" and renovation appropriations in the  - 8 - state budget. Furthermore, many bugetary capital construction projects are now being funded by PCBC loans rather than grants. The state budget includes appropriations for the various banks, called "bank credit funds." The cash plan, credit plan and state budget are closely interrelated and partially determined by each other. The MOF and PBC must coordinate their activities carefully to minimize overlap. Jurisdictional uncertainties remain regarding authority over loans for investment, working capital financing, and procedures required for obtaining foreign currency loans. Coordination of these activities is the responsibility of the State Planning Commission. A financial summary of the state banking system is contained in Annex D, Table 1.1. C. Recent Banking Reforms and Rural Finance 1.19 Five main themes can be identified in recent reforms of China's financial system. One is reassertion of the independence and organizational integrity of the banking system, combined with the establishment or restoration of certain specialized financial institutions. Attention is focussed on redefining the relationship between banks and other supervisory organs responsible for overseeing the economy. The second main trend involves strengthening and transforming the banks' position vis-a-vis their clients. Bank decisions affecting clients are to be based on independent use of economic criteria rather than administrative fiat or blind adherence to detailed plans. "Economic levers" such as interest rates and repayment terms should partially supplant bank directives in guiding the actions of basic-level borrowing units. Loan agreements are to be formalized in economic contracts between bank branches and borrowing entities. Significantly, the right of banks to make independent judgments on loan applications and, if necessary, refuse to grant credit is strongly affirmed. 1.20 The third, and in many ways the most important reform from the banking system's own point of view, is internal decentralization. This has two aspects. Administratively, local bank branches are being given more flexibility in the important area of credit planning. They are now allowed to reallocate loans among different categories of the credit plan and can use the proceeds of an increase in deposits or more rapid turnover of loans to extend more loans in their localities. Bank branches are considered to be economic units as well as administrative bodies. All branches are considered as independent accounting units which have responsibility for their respective profits and losses. 1.21 A fourth theme of current reforms is to improve the quality of the financial system's human capital. This ties in closely with a more economic orientation of the system and bonuses for its employees. It also is closely related to the reassertion of bank independence with regard to personnel  decisions. Better training of new bank cadres and extensive courses for veteran and leading personnel, who in some cases know little about the mechanics of bank operations, are the main means of achieving this goal. /1 1.22 The fifth current is closely related to internal decentralization. Bank branches, as well as trust and investment corporations they may set up, are to act as financial intermediaries, bringing together the idle, surplus funds of economic units and government organizations and using them to make investments that will foster local economic development. The key innovation lies not in mobilizing surplus funds, which is a legitimate, though in the classic socialist model a relatively unimportant, role of banks. What is really new, and of particular significance for future development of the rural financial system, is the active search for local investment opportunities and the banks authority to make investments in projects that may not be part of the state plan. /1 A report from the PBC gives both an indication of the magnitude of this task and its importance in the view of the banking system: "A short-term plan and a long-term program have been worked out by the People's Bank of China to raise the educational level of its staff. The short-term plan stipulates that before the end of 1983, all leading cadres and staff, including new recruits, will get two-to-six months training on a rotation system. In 1980, 68,464 people took the two-month vocational training. This is about 30% of all cadres and workers scheduled for such training. According to the long-term program, by 1990 a comprehensive college and middle-school education system will be set up within the bank so that workers- education will be institutionalized. A bank official said that China would set up a national education committee within the banking system. A college was planned for the advanced training of cadres." (NCNA 5/29/81, in BBC FE/6753/BII/4)  - 10 - 2. RESOURCE MOBILIZATION AND ALLOCATION IN RURAL AREAS /1 2.01 During the past few years the pattern of development expenditures and financing in China has changed significantly. This reflects in part the Government's efforts to improve the efficiency /2 of the economy by strengthening and increasing the role of the banking and financial system. But it also reflects other institutional changes aimed at the overall objective of improving efficiency. These include the reduced emphasis on state budget financing of investment, the devolution of the public finance system, and the development of new production responsibility systems throughout the economy. In rural areas the new production responsibility systems have been of particular importance. This chapter provides an overview of the reforms and changes in the pattern of expenditures and financing of rural development. Due to the limited availability of quantitative information, the overview is mainly descriptive but, where feasible, estimates have been made of the extent of resource mobilization and the amount and source of finance for investment and operating expenditures in rural areas. A. Resource Mobilization 2.02 Rural development in China has been based to a large extent on local resources and much self-reliance. In particular the rural collective economy has remained quite isolated from the rest of the economy, undertaking most investment and production activities on its own and using its own resources. Nonetheless, the Government has mobilized substantial resources /I For the purposes of this discussion, rural areas are defined as all areas outside of the 203 cities and the 2,300 county towns. The most significant implication of this definition is that in the industrial sector the only activities to be addressed in detail are those of commune and brigade enterprises. /2 At various places in this report, a distinction is made between financial efficiency (where emphasis is placed on the profitability of a project to the organization or organizations that are undertaking it) and economic efficiency (where emphasis is placed on economic returns and on the contribution of a project to national economic development). For a further discussion of this distinction see paras. 5.31-5.35, and "Economic Evaluation of Investment Projects: Possibilities and Problems of Applying Western Methods in China," a paper prepared within the World Bank as background material for a team of Chinese experts who are preparing a project appraisal manual for the China Investment Bank.  - 11 - from rural areas mainly to help finance its industrialization program but also to assist agriculture and rural development. In recent years there has also been a growing amount of rural savings and an increase in the amounts of financial intermediation within the rural sector. Fiscal Resources 2.03 For the economy as a whole, fiscal revenues (including both state budgetary and extrabudgetary revenues) are of great importance. More than 30% of GDP flows through the state budget alone. Accordingly, efforts to improve the efficiency of the fiscal system by devolving more authority to local governments and emphasizing credit rather than budget financing of various development expenditures are an integral part of the Government's overall program of economic reform. These fiscal reforms are, however, of less significance for rural institutions than for urban institutions because rural revenues remain a relatively small proportion of rural incomes and of total budget and extrabudgetary revenues. 2.04 Budget revenues come primarily from taxes and the profits and depre- ciation funds of state run enterprises and are divided into central and local portions (Annex D, Table 2.1). A much smaller share of revenues is retained by rich provinces than by poor provinces. A formal revenue sharing scheme was introduced in 1980 and provinces have been encouraged to extend revenue sharing principles down to the county level. Revenues retained by the provinces are divided into two parts: a nondiscretionary component the use of which is largely stipulated by the central government and a discretionary component which is used to cushion fluctuations in planned receipts and expenditures and for uses determined by local authorities./l The major rural revenues are the agricultural tax and taxes on commune and brigade enterprises (CBEs). But the agricultural tax, which is assessed as a percentage of a hypothetical normal yield per mu fixed many years ago, has remained remarkably stable over the years and now accounts for less than 3% of total revenues. Total revenue from CBE taxes was only Y 2.0 billion in 1979 or less than 5% of total revenue from industrial and commercial taxes and less than 2% of total budgetary revenues. /1 The sources of discretionary funds probably vary from province to province. But in most provinces they are believed to include: about 3-5% of total ex ante budgetary expenditures; a proportion of the funds from overfulfillment of revenue collection plans; surpluses accruing from economizing on expenditures; and some local taxes including license fees for transport vehicles, property taxes on urban housing, slaughter taxes, sales taxes on draft animals and sales taxes at markets.  - 12 - 2.05 Extrabudgetary funds are of two types and have been growing rapidly in recent years. One set of extrabudgetary funds is under the direct control of certain state and collective enterprises and the local bureaus and ministerial systems to which they belong. They include the profits and depreciation funds that are retained by those enterprises and bureaus /1 plus such resources as highway maintenance fees, waterway maintenance fees, afforestation funds, incomes from productive activities of schools, management fees for markets, housing management fees, etc. The other set of extrabudgetary funds accrues directly to local governments and includes a portion of the profits of county run collective enterprises as well as local surcharges on industrial and commercial taxes, agricultural taxes, etc. Relatively little information is available about these funds except that they have been growing rapidly and are now a larger source of finance for total capital construction than budgetary revenues. A review of the sources and uses of these funds at the county level suggests that most of the revenues arise from industrial enterprise profits and are largely used for investment in similar types of enterprise. The share of rural revenues in these funds is therefore relatively small. 2.06 The Government has in the past been able to mobilize substantial resources in rural areas through the establishment of a pricing structure designed specifically to generate large profits for state industrial enter- prises. In recent years this has been offset in part by increases in agricultural prices, the financial effects of which have been considerable./2 But a comparison of agricultural prices with the prices of processed commodi- ties (for example, sugarcane prices with prices for refined sugar) suggests that this price structure still generates large profits for industrial enterprises. As a result, commune and brigades are setting up their own processing industries which may be financially viable but economically inefficient (para. 4.17). /1 An industrial enterprise under the control of one of the industry ministries would pay some of its profits as tax to the finance bureau or remit some of its profits to the finance bureau. This would be included in budget revenues. Of the remaining profits, some would stay with the enterprise and some would be remitted to the industrial bureau. /2 The World Bank Report No. 3391-CHA, Annex C, P.58, suggests that the terms of trade between agriculture and industry moved significantly in favor of agriculture between 1970 and 1979.  - 13 - Household Savings 2.07 The household sector in rural areas is playing an increasingly important role in resource mobilization. Some household savings are used directly by the households themselves for investment in private plots, housing etc. But the savings deposits of commune members have also increased rapidly from Y 3.9 billion at the end of 1976 to Y 11.7 billion at the end of 1980 and Y 17.0 billion at the end of 1981 (Annex D, Table 3.13). The rate of growth of such deposits has been much higher than the growth of rural tax revenues. Household deposits are also growing more rapidly than other deposits; at the end of 1980 they accounted for 43% of total deposits with rural credit cooperatives compared with 36% at the end of 1979. Table 2.1: SAVINGS AND TAXES IN RURAL AREAS, 1977-80 1977 1978 1979 1980 ------- billion yuan --- Increase in savings deposits of commune members 0.7 0.9 2.3 3.9 Agricultural tax 2.9 2.8 3.0 Commune and brigade enterprises taxes 2.0 Source: Annex D, Tables 2.3, 2.4 and 2.5. 2.08 It is possible that some of the increase in rural savings is involuntary in the sense that these funds would have been used to purchase consumer goods if more high quality goods had been available in rural areas. But it also appears that the rapid growth in rural incomes (especially noncollective incomes), coupled with increases in interest rates and an expansion in the savings network, have been contributing factors. In addition, the Government's emphasis on "voluntary deposit, free withdrawal, interest payments and protection of the anonymity of savers" /1 has encouraged households to convert some of their currency holdings into bank deposits. Other Rural Resources 2.09 Despite their rapid growth, however, household savings are still relatively small in relation to total rural resources. The major determi- /1 ZGJR No. 6, 9/30/79, p. 14.  - 14 - nant of rural resource mobilization remains the decisions of rural organiza- tions, particularly collective enterprises and groups, on the amount of labor accumulation and on how much of current revenues are set aside for future production and investment expenses. In the case of production teams (the basic collective production unit), deductions from total gross output (sales plus retained production) are made for: costs of purchased inputs, taxes, grain and cash reserves to be used, inter alia, to cover some of the following year's expenses, and accumulation and welfare funds./l The remaining income is then allocated to individual household heads within the team, primarily according to household accumulations of work points. Teams decide on their own work points system but most systems take account of the difficulty of a specific task as well as the amount of time spent on it. Many also include piecework elements./2 Work points can be accumulated through participation in production activities (at any level of the collective system), as well as through work on infrastructure or other investment projects. Government guidelines on the distribution of output and income suggest that 20% of current revenues should be kept for production expenses in the following year and 5-7% of net income should be allocated to the accumulation fund. But many of the poorer collective units are unable to achieve such rates and, as a result, face great difficulties in improving agricultural productivity or developing profitable commune and brigade enterprises. B. Financing of Agriculture 2.10 Despite the rapid growth of rural industries, agriculture remains the most important activity in rural areas and the major source of livelihood for most of the rural population./3 Responsibility for agricultural /1 These funds are generally placed on deposit with the local rural credit cooperative or ABC branch. /2 Changes in these systems are taking place as part of the process of reforming the organization and management of agricultural production (para. 2.17). /3 The activities and institutions covered under the term "agriculture" need to be carefully defined. In the national accounts the term agriculture includes the activities of industrial enterprises run by production brigades and teams. Commune-run enterprises are excluded. In this discussion, however, all commune, brigade and team enterprises are excluded from agriculture, regardless of whether they are involved in industrial or more directly agricultural activities (such as running a tea plantation or a dairy operation). The organization and financing of commune, brigade and team enterprises is then discussed separately.  - 15 - investment and production is divided among a number of different institutions including central and local government, state farms, rural collectives (production teams, brigades and communes), and individual households. To date, government efforts to improve the overall efficiency of agricultural development expenditures have focussed on the introduction of new production responsibility systems in state farm and rural collective agriculture, an expansion in the area devoted to private plot agriculture and an increase in the role of the banking system in financing expenditures in state, collective and private plot agriculture. Little change has taken place in the organization and financing of central and local government activities in agriculture. Tables 2.2 and 2.3 provide rough estimates for 1979 on the extent and sources of finance for expenditures on agricultural investment and production. Central and Local Government /1 2.11 The government itself directly undertakes a relatively small share of total agricultural investment (Table 2.2), but its role in investment and general agricultural support is still very important. At the central government level there are five ministries and two specialized agencies directly concerned with agriculture /2. At the province level some of the rural-oriented departments corresponding to central ministries may be merged with the agriculture department. At the prefecture and county levels, staff are usually grouped under an agricultural office. Subordinate organizations are linked both to a parent ministry and to an appropriate level in local government. Central and local government institutions are of particular importance for water conservancy. In the case of a major water conservancy scheme,/3 for example, the departments, bureaus and offices of the Ministry of Water Conservancy are directly responsible for construction and maintenance of the headworks and the main and branch canals. They may also take responsibility for certain medium-scale schemes. Another major government activity is the provision of agricultural research, extension and training services. /1 Because of major differences in organization and financing, central and local government activities are discussed separately from the activities of other state institutions such as state farms. /2 The Ministries of Agriculture, Water Conservancy, Forestry, Agricultural Machinery and State Farms and Land Reclamation, the General Bureau of Aquatic Products and the Central Meteorological Bureau. /3 Generally larger than 20,000 ha or a reservoir larger than 100 million cu m.  - 16 - Table 2.2: ESTIMATES OF INVESTMENT EXPENDITURES IN AGRICULTURE, 1979/a (Y billion) Source of finance Budget and Own funds Insitution undertaking extra budgetary Bank and agricultural investment funds loans resources Total Central/local government 2.3 - - 2.3/b State farms 0.5 0.1 0.3 O.9/c Communes /brigades/ product ion teams 2.2 2.1 8.4 12.7/d Households/Private Plots - 0.3 4.7 5.0/e Total 5.0 2.5 13.4 20.9 Sources and Notes: /a Includes fixed investment, work in progress and increase in inventories. /b Based on World Bank Report No. 3391-CHA Annex A, Table 2.4, but assuming that (i) half of state capital construction in agriculture was for hydroelectric power (i.e., industry) and (ii) Y 0.5 billion was for capital expenditures on state farms. /c Breakdown of state farm expenditures by source of finance based on data from Ministry of State Farms on sources of investment finance in Heilongjiang in 1979 and on data in Zhongguo Nongken No. 6, June 1981, p. 2-4. /d Based on World Bank Report No. 3391-CHA Annex A Tables A 17, 24 and A 25 but making the estimate for total capital expenditures, not just fixed investment expenditures. The breakdown of commune capital expenditures by source was calculated as follows: (i) Budget funds estimates are based on World Bank Report No. 3391-CHA, Annex A, Table 4.8 and include Y 0.7 billion of commune support (the remainder of this item goes as support to commune and brigade enterprises) and an esti- mated Y 1.5 billion in subsidies for small-scale water conservancy schemes; (ii) own funds include the 45% of investment which is labor costs and Y 2.7 billion of support for agriculture out of commune and brigade enterprise profits; (iii) the residual of Y 2.1 billion is bank loans. /e Based on World Bank Report No. 3391-CHA Annex A Tables A 17 and A 24 and assuming that 25% of loans to individuals are for capital expendi- tures in agriculture.  - 17 - Table 2.3: ESTIMATES OF OPERATING EXPENDITURES IN AGRICULTURE 1979/a (Y billion) Source of finance Budget and Own funds Insitution undertaking extra budgetary Bank and agricultural production funds loans resources Total State farms 0.3 0.2 1.0 1.5/b Communes/brigades production teams 1.0 13.6 19.4 34.0/c Households/Private Plots - 0.3 2.2 2.57d Total 1.3 14.1 22.6 38.0 Sources and Notes: /a Excluding expenditures on labor. Government expenditures on research, extension and administration are also excluded. /b Based on information on gross agricultural output of state farms from Zhongguo Baike Nianjian 1980 translated in FBIS 6/10/81 and on informa- tion from Heilongjiang on the relationship between production costs (excluding labor) and gross agricultural output. /c Based on World Bank Report No. 3391-CHA Annex A, Table A7 but excluding (i) Y 1.5 billion of expenditures on inputs for state farms; and (ii) Y 2.5 billion of estimated expenditures on inputs for private plot agriculture. Breakdown of these expenditures by source of finance based on information from Shandong and Guangxi provinces. /d Assumes that 25% of loans to individuals are for agricultural production expenses.  - 18 - 2.12 Financing for the agricultural activities of central and local government is provided almost entirely from the state budget. In the case of county-level activities, use is very occasionally made of extrabudgetary funds but the amounts of such funds going to agriculture are believed to be quite small. State capital construction expenditures in agriculture (including hydroelectric power) averaged less than Y 1 billion in the late 1950s, or less than 10% of total state capital construction. But they rose to Y 2.4 billion (14% of the total) in 1965 and Y 6.2 billion (12% of the total) in 1979 before falling to Y 4.5 billion (8% of the total) in 1980. It is under- stood that as much as half of these expenditures were for hydroelectric power (i.e. industry rather than agriculture), but most of the other expenditures were accounted for by investment in major irrigation and flood control projects. In recent years expenditures for agricultural support have been growing more rapidly than capital construction expenditures and now account for over 60% of state budget expenditures on agriculture (compared with 40% in the mid 1960s). A portion of these funds goes as support to collectives and state farms but most are used to finance the agricultural support services and maintenance work of central and local government organizations. Table 2.4: BREAKDOWN OF STATE BUDGET EXPENDITURES IN AGRICULTURE, 1965-80 /a (Y billion) 1965 1970 1975 1976 1977 1978 1979 1980 Total Expenditure on Agriculture 4.080 n.a. 7.809 8,592 8.666 12.802 15.252 12.200 Capital con- struction 2.351 n.a. 3.556 3.991 3.598 5.107 6.241 4.460 Agricultural support 1.729 1,591 4.253 4.601 5.068 7.695 9.011 7.740 Of which commune support 0.055 0.203 0.916 1.119 1.235 1.620 1.085 0.840 /a Includes hydroelectric power. These figures are budget appropriations and should not be compared with the figures in Table 2.2 which are actual expenditures. Source: Ministry of Finance.  - 19 - State Farms 2.13 In relation to the collective sector in agriculture the state farm sector is small. It accounts for less than 5% of the country's cultivated area and a very small proportion of investment and operating expenditures. In the past, the major rationale for the development of such farms was to encourage population migration from the densely populated East Coast to the less populated and less developed border areas and to reclaim wasteland often in difficult agroclimatic circumstances. State farms now figure prominently in the Government's overall program for expanding marketable food crop production. In addition to agricultural production, state farms are being encouraged to expand industrial and commercial activities (para. 2.29). They also provide workers and their families with health care, education, etc. 2.14 State farms, like other state enterprises in China, were previously subject to a high degree of central control. Farming operations were run on a central, consolidated basis and all state farm revenues and costs were aggregated. Production was directed by crop and area from the center. There was little incentive at the farm level for efficient production because all profits had to be remitted in full to the center and losses were absorbed by the center. Since 1979 efforts have been made to improve efficiency by giving individual farms more autonomy in investment, production and financial management. In addition to decentralizing decision making for all except large civil works (reservoirs or dikes) and making farms responsible for their own profits and losses, the reforms involve the introduction of new job responsibility systems designed to decentralize management and to reward those who increase the quality and quantity of production. A major element of the new system is the extensive use of "contracting" among the farms internal management units: farm, subfarm and brigade. Brigades may make further contracts with work groups and even families and individuals. In the contracts production and profit targets are specified and units are rewarded if they exceed the targets or penalized if shortfalls occur. Table 2.5: INVESTMENT IN THE HEILONGJIANG STATE FARM SYSTEM, 1979-81 Individual farm provided Budget investment Total funds Bank loans funds ---------------