Macroeconomic management in China : proceedings of a conference in Dalian, June 1993

EAST ASIA & PACIFIC REGION SERIES 222EWorld Bank Discussion Papers China and Mongolia Department Macroeconomic Management in China Proceedings of a Conference in Dalian, June 1993 Edited by Peter Harrold E. C. Hwa Lou jiwel Recent World Bank Discussion Papers No. 164 How Do National Policies Affect Long-run Growth?: A Research Agenda. William Easterly, Robert King, Ross Levine, and Sergio Rebelo No. 165 Fisheries Development, Fisheries Management, and Externalities. Richard S. Johnston No. 166 The Building Blocks of Participation: Testing Botton-up Planning. Michael M. Ccrnca No. 167 Seed System Development: The Appropriate Roles of the Private and Public Sectors. Steven Jaffee andJitendra Srivastava No. 168 Environtnental Management and Urban Vulnerability. Alcira Kreimer and Mohan Munasinghe, editors No. 169 Common Property Resources: A Missing Dimension of Development Strategies. N. S. Jodha No. 170 A Chinese Province as a Reform Experiment: The Case of Hainan. Paul M. 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Poverty Reduction in East Asia: The Silent Revolution. Frida Johansen. Discussion Paper No. 203. China: Reform and Development in 1992-93. Peter Harrold and Rajiv Lall. Discussion Paper No. 215. EAST ASIA & PACIFIC REGION SERIES 222 H World Bank Discussion Papers China and Mongolia Department Macroeconomic Management in China Proceedings of a Conference in Dalian, June 1993 Edited by Peter Harrold E. C. Hwa Lou Jiwei The World Bank Washington, D.C. Copyright ( 1993 The International Bank for Reconstruction and Development/THE 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 November 1993 Discussion Papers present results of country analysis or research that are circulated to encourage discussion and comment within the development community. 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Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. The complete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from the Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66, avenue d'Ina, 75116 Paris, France. ISSN: 0259-210X At the time this paper was written, Peter Harrold was principal economist in the Country Operations Division, Country Department II (China, Mongolia), of the World Bank's East Asia and Pacific Regional Office. He is currently economic adviser in the Private Sector Development and Economics Division of the Bank's Africa Technical Department, Africa Regional Office. E. C. Hwa is senior economist in the Bank's Resident Mission in Beijing, People's Republic of China. Lou Jiwei is director, Macroeconomic Department, System Reform Commission, Beijing. Library of Congress Cataloging-in-Publication Data Macroeconomic management in China : proceedings of a conference in Dalian, June 1993 / edited by Peter Harrold, E. C. Hwa, and Lou Jiwei. p. cm. - (World Bank discussion papers ; 222) Includes bibliographical references. ISBN 0-8213-2722-4 1. China-Economic policy-1976-Congresses. 2. Chna-Economic conditions-1976-Congresses. 1. Harrold, Peter, 1952- II. Hwa, Erh-Cheng. Ill. Lou,Jiwei, 1950- . IV. Series. IC427.92.M329 1993 339.5'0951-dc20 93-39544 CIP CONTENTS Page No. Foreword ....................................... Vii List of Contributors ................................ viii A bstract. . ...................................... ix Currency Equivalents............................... x Introduction and Overview ........................... xi Opening Remarks ................................. 1 Shahid Javed Burki Developing China's Macroeconomic Management ............. 5 Guo Shuqing Comment: LawrenceLau .......................... 15 Monetary Policies in China's Economy in Transition ........... 35 Wu Xiaoling and Xie Ping Comment: Chris Allsopp and Cyril Lin .................. 47 Market Economy and Macrocontrol of Finance .............. 57 Liu Kegu Market Economy and Tax Reform in China ................ 69 Xu Shanda and Ma Lin Comment: Nicholas Stem and Athar Husain ............... 81 Distribution System Reform in the Transition to a Market Economy 91 Li Yuan Comment: Athar Husain and Nicholas Stern ............... 103 China's Industrial Policy During Economic System Transformation . 107 Su Ning Comment: NicholasLardy .......................... 119 Reform Sequencing and State Asset Management in China ....... 125 Zhou Xiaochuan Comment: PeterHarrold .......................... 145 Comment: AnjaliKumar........................... 159 Closing Remarks andConclusions....................... 163 Shahid Javed Burki Participants ..................................... 171 - vii - FOREWORD The World Bank's economic and sector work program in China is a very active one ranging over a wide spectrum of topics from macroeconomics to health and education. Each year we publish a handful of our formal studies, but thus far most of the background papers and informal reports, many of them containing valuable analysis and information, have remained outside the public domain. Through the China and Mongolia Department's contributions to the East Asia Discussion Papers, we hope to make available to a broad readership among the China watchers and development communities papers which can contribute to a better understanding of China's modernization. This discussion paper edited by Messrs Harrold, Hwa and Lou should contribute significantly to that process. In June 1993, I had the pleasure to attend a most significant conference in Dalian, China, which brought together many of China's leading reformers with renowned China scholars and experts from the World Bank. At that conference, we reviewed a number of papers prepared by Chinese experts, and together formulated a series of recommendations to the Chinese government. These covered both the short-term situation, and necessary measures to cool down the overheated economy, as well as deeper measures to improve macroeconomic management in China over the medium term. This conference was held with the full support of Vice-Premier Zhu Rongji, to whom the final outcome of the conference was submitted. Given the quality of the papers and the debate, and the outcome, we decided to preserve the proceedings of this important conference by preparing this volume. We hope this proves to be of interest both to those who specialize in Chinese affairs, as well as those with a broader interest in the problems of transition. Shahid Javed Burki Director China and Mongolia Department - viii - List of Contributors Shahid Javed Burki, Guo Shuqing, Lawrence Lau, Wu Xiaoling, Chris Allsopp, Xie Ping, Cyril Lin, Liu Kegu, Nicholas Stem, Xu Shanda, Ma Lin, Athar Hussain, Li Yuan, Nicholas Lardy, Su Ning, Anjali Kumar, Zhou Xiaochuan, Peter Harrold. - ix - Abstract This Discussion Paper presents the proceedings of a conference that was held in Dalian, China in June 1993. This was attended by many leading Chinese reform economists, as well as foreign scholars specializing in Chinese affairs and World Bank staff. It was focused on measures to improve macroeconomic management in China, but it took place against a background of the overheating of the Chinese economy, which developed over the first half of 1993. Therefore, the conference was concerned both with measures to address the short term problems facing the economy, as well as reforms to overcome the deeper, structural issues. Papers were presented by the Chinese participants on such topics as financial sector reform, fiscal policy, the role of industrial policy, and state asset management. The foreign participants prepared comments on these papers, and the meeting concluded with a clear set of recommendations and proposals, which were submitted to the Chinese leadership at a very opportune time, in terms of policy formulation. This paper therefore seeks to preserve the contents of what turned out to be a significant conference. CURRENCY EQUIVALENTS Up to December 15, 1989 Up to November 29, 1990 At June 30, 1993: $1.00 = Y 3.72 $1.00 = Y 4.72 $1.00 = Y 5.70 Y 1.00 = $0.27 Y 1.00 = $0.21 Y 1.00 = $0.18 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS DRC - Development Research Center of the State Council SCETC - Economic and Trade Commission FDI - Foreign Direct Investment FEACs - Foreign Exchange Adjustment Centers FTCs - Foreign Trade Companies GATT - General Agreement on Trade and Tariffs GDP - Gross Domestic Product GNFS - Goods and Nonfactor Services GVIO - Gross value of Industrial Output IMF - International Monetary Fund MFN - Most-Favored-Nation (status) MOF - Ministry of Finance NBFIs - Nonbank Financial Institutions NPC - National People's Congress NTBs - Nontariff Barriers PBC - People's Bank of China SAEC - State Administration of Exchange Control SAMB - State Asset Management Bureau SEZ - Special Economic Zones SOE - State-Owned Enterprise SPC - State Planning Commission SRC - State Commission for Restructuring the Economic System TVE - Township and Village Enterprise BOC - Bank of China STB - State Taxation Bureau SIC - State Investment Corporation - xi - INTRODUCTION AND OVERVIEW Introduction 1/ In October 1992, the 14th National Congress of the Communist Party of China gave a new impetus to the process of economic reform in China, by adopting the guiding principle of the "socialist market economy". This was to be an economy that remained socialist in nature, in the sense of maintaining a wide range of public ownership of assets, but in which resource allocation was essentially to be determined by market forces rather than by the government, as in the past. It was therefore intended to move to indirect control of the economy through the instruments of macroeconomic management. This obviously had major implications for the conduct of fiscal and monetary policies, as well as the style and scope of industrial and trade policies, and the management and ownership of enterprises. The State Commission for Restructuring the Economic System (or System Reform Commission (SRC)) and the World Bank have been collaborating closely for many years. In particular, since 1985, they have jointly sponsored a series of important high-level policy seminars on key reform topics, with one major conference each year. Soon after the Congress had been completed, SRC approached the Bank with the idea of arranging the 1993 conference on the topic of macroeconomic management. It was decided to hold this conference in the North-East city of Dalian in June 1993, after the National People's Congress had adopted a work program for the government to carry out the guiding principles of the 14th Congress, and after a new government had been appointed. At that time, the economy was booming, but was judged to still be in a recovery stage from the below-potential growth of 1989-91. The organizers of the conference did not foresee at the time that this high growth pace of 1992 was going to continue unabated into 1993, causing the economy to run into overheating problems by mid-year, with the rising threat of this spilling over into generalized inflation. 2/ Moroever, this rapid growth and overheating in 1993 was associated with an evident and serious absence of macroeconomic control, and especially under-regulation of the financial sector and excessive expansion of the money supply. By the time the conference came to be held in mid-June, GDP was growing at a rate of 14 percent per annum, industrial output at 25 percent per annum, the urban cost of living was rising by close to 20 percent, and the balance of trade had just turned negative, with imports growing by over 20 percent, thereby relieving some of the inflationary pressure. To many economists 1/ Throughout this paper, Chinese names are presented according to Chinese practice. i.e. family names come first, and personal names follow. For example, one of the editors is Lou Jiwei. His family name is Lou and his personal name is Jiwei. 2/ For a discussion of the recent economic situation in China, see Peter Harrold and Rajiv Lall, "China: Reform and Development in 1992-93', World Bank Discussion Paper No. 215, August 1993. - xii - and policymakers, this was leading to a repeat of the economic situation of 1988, with all its consequences. Therefore, the conference took place against the background of a manifestation of the very problems it had been designed to address. This added a greater sense of urgency to the proceedings of this conference in two ways: it generated a concern to address not only the medium-term reform issues related to creating the institutions and instruments of macroeconomic management, but also to identify measures that would be appropriate in addressing the problems of the overheating of the economy in the short term. Second, it added to the depth and seriousness of the discussions on medium-term macroeconomic reforms, as it was by this time evident that these would have to be accelerated if China was to avoid further repetitions of "boom-bust" cycles it had been experiencing in recent years. This dual purpose of the conference was spelled out clearly by Shahid Javed Burki in his opening statement. The conference therefore turned out to be very timely, and its output was a key input to the government deliberations that led to a package of measures in July 1993, designed to cool off the economy in the short term. Its deliberations have also been fed into the discussions that are ongoing at this time in China to design a deeper program of reforms to establish an indirect system of macroeconomic management, and notably through much deeper fiscal and financial reform. Given this situation, it was decided by SRC and the World Bank that it would be appropriate to preserve the proceedings of this conference for future reference, and for the interest of others who observe the Chinese economy. From the outset, this conference was conceived in a somewhat different way that many similar events in the past. It was decided to minimize the focus on relevant international experience in these areas, and instead to focus all attention on current Chinese thinking on these issues. Therefore, the SRC identified the seven main areas on which it wished to focus: macroeconomic management, monetary policies, fiscal policy, taxation, distribution, industrial policies, and state asset management. It identified 9 of the most prominent Chinese economists, either in government or in government think-tanks, and requested them to prepare position papers on the seven areas concerned. In conjunction with the Bank, seven foreigners were identified as commentators on these papers. These foreigners were selected not only for their knowledge of the issues concerned, but also because of their deep knowledge of these sectors in China, as they are all China specialists to a greater or lesser degree. It was therefore possible to go very deeply into these issues, and cover a lot of ground in depth in a relatively short time. Wu Jie, Vice-Chairman of SRC, and Shahid Javed Burki, Director of the China and Mongolia Department of the World Bank agreed to act as co-chairmen of the conference. Overview The seven papers and their related commentaries provide a very comprehensive description of the problems facing macroeconomic management in China today, and a range of solutions to address these problems. Guo Shuqing 's paper sets the scene for more detailed papers that follow. He examines the current state of macroeoconomic managment in China, and recommends what has to be done to improve this form of management. He argues that the economy has changed considerably in the reform era, and that the old methods of economic - xii - management are no longer applicable. Indeed, he notes that many of the old instruments, such as investment and price control, continue to be exercised, but that their effect is minimal. He argues that all these should be abandoned, and that more and more attention should be given to developing new forms of macroeconomic management, notably fiscal, monetary and exchange rate policy. These, he argues, are the job of central government, and they cannot be exercised at the local level, which is happening to some extent at present. He thus concludes with a call for deeper reforms in these three key areas. Wu Xiaoling and Xie Ping address the key question of financial sector reform. They find that the present system has a tendency to lead to an overexpansion of credit, and to a harmful, excessive reliance of enterprises on bank credit. In particular, this results from overexpansion of credit in order to postpone enterprise restructuring. This is because, in their view, there is too much focus on economic growth in designing monetary policy. Rather, the focus should be on stability of the currency and on creating an efficient financial sector. The People's Bank should operate primarily via open-market operations. This requires two things, in their view. First, the budget should take over the financing of restructuring and redistribution, and should no longer rely on PBC overdrafts. Second, the policy lending functions of banks, which require PBC credit, should be separated into policy lending institutions, leaving the specialized banks to become true commercial banks. This will also require the reorganization of the PBC, with a branch network based on economic rather than administrative areas, and with much more developed information systems. This would leave PBC branches to focus on supervision, settlement and research. Finally, it will also require a gradual liberalization of interest rates and exchange rates, permitting them to be market- determined. There are two papers dealing with the key area of fiscal reform. Liu Kegu describes the problems that exist with the present tax contracting systems, both with enterprises and between the central and local governments. The fiscal reform challenge is to move beyond these to introduce new fiscal systems. He argues that overall national revenue is too low, and that the center's share in it has fallen too far, and that this weakens the state's ability to manage the economy. For these new systems, he calls for the early implementation of a new enterprise tax, which would be neutral between ownership or location. He finds fault with the present experiments in tax sharing between the central and local governments, and looks forward to the identification of separate taxation systems and administrations. The raising of revenue will require new taxes, such as those on property, but he believes that indirect taxes will continue to provide the lion's share of revenue. Finally, he looks forward to a new system of management and regulation, which will rely much more heavily on public accounting systems. Xu Shanda and Ma Lin review the role of taxation in a market economy, and the principles for designing a ne tax system. They find that the present system falls short, and is in need of deep reform, and they put forward a set of principles for this reform. On particular taxes, they attach great importance to the new Enterprise Income Tax, which will apply equally to domestic and foreign enterprises. They regard this as a fundamental element in enterprise reform. The conversion of loan repayment to an after-tax basis is the key for them, as the present system leads to investment hunger, and the reform will make enterprises responsible for investment decisions. The reform and further development of the VAT is a second key element, and they argue that it should have a wider base and simpler rates than the present VAT. They - xiv - note that product taxes will be needed for a while, but will eventually just apply to special commodities such as alcohol and tobacco. They also note the need to expand the local tax base, and to establish separate tax jurisdictions. Finally, they attach major importance to the development and application of tax laws. The question of distribution is complex and thorny, and is the subject of a paper by Li Yuan. The change to the market involves a change from government distribution of income, market distribution, and he describes how this has been happening. The difficulty, he argues, is to balance overcoming "egalitarianism" -- the tendency for earnings to be the same regardless of productivity -- with the need to avoid "unfair" income distribution and threatening social security. The solution lies in two areas: to improve labor markets, not least by increasing competition among enterprises, so as to have rational "primary" income distribution, even if his leads to some people getting rich first; and to creating new institutions of secondary distribution, to meet income maintenance and distribution objectives. He therefore attaches great importance to the improvement of the present social security schemes under development, especially their expansion beyond the public sector, and improvements in their system of funds management. Su Ning looks at the future of industrial policy in China. This should be concerned both within industrial structure and with industrial organization, and be correcting for market failure or for the "immaturity" of the industrial sector. He points out that industrial policy has always played a key role in China, but that it was primarily a planning approach. This raises the equally difficult problem of "government failure", and it may be that government failure is more harmful than market failure. He considers that the new industrial policy that was issued in 1989 had a useful role to play during the rectification period, but that it had several faults. Essentially, it was still a remnant of the old system, being essentially a "catalog" of preferred and disfavored industries. Moreover, it did not solve the problem of the underdevelopment of the basic industries, small scale of production, low efficiency in old industries, and lack of development in the West and Central parts of China. These, he believes, should be the focus of the new industrial policy, which should be focused on government's role in making markets work. The last paper, by Zhou Xiaochuan, is in two parts. In the first part, he examines the role of privatization in socialist economic reform, and its timing. He concludes that this should not be an early emphasis of reform, and that several attempts at this in other countries have come to grief. Rather, he argues, the emphasis at China's stage of reform, should be on commercialization and marketization of state-owned enterprises. This involves a range of parallel reform efforts, especially in pricing, fiscal policy and trade policy. He points out the considerable success China has enjoyed in marketization, and in developing competition. However, he is less sanguine about progress in ownership reform in China, and proposes new ways for the ownership rights of the state to be represented, while being separated from government. SOEs should be corporatized, and shares vested in holding companies, which would supervise the performance of management. A critical component of the structure he proposes is a Public Ownership Commission which would report directly to China's parliament. - xv - In his closing statement, Shahid Javed Burki presented a set of recommendations for short term actions by the Chinese authorities, and priorities for medium-term reform of the system. It was a strong recommendation that action was necessary in the short term to avoid a later "hard-landing" for the economy, and that this short term action should be a combination of indirect measures, such as interest rate increases, and direct measures, such as stricter investment controls. In terms of priorities for reform, he called for a radical restructuring of the central bank, especially to eliminate all non-central bank functions and reduce local government influence on the central bank, and a more aggressive approach to fiscal reform. This latter recommendation was especially because of the need for the budget to take on a range of financing obligations that were currently the responsibility of the commercial banking system. This conference and these proceedings would not have been possible without the efforts of a wide range of people. The editors would like to acknowledge in particular; Vice- Chairmen Wu Jie and Gao Shangquan of the System Reform Commission, Shahid Javed Burki, Director of the China and Mongolia Department of the World Bank, and Pieter Bottelier, Chief of the World Bank Resident Mission in China, for their unstinting support to the seminar, and allocation of staff and resources; Mr. Ye Sen and the staff of the International Department of the System Reform Commission, who carried much of the burden of administration; Mr. Tian Yinong and Mr. Jin Liqun of the Ministry of Finance, for their financial and intellectaul support; the staff of the System Reform Office of Dalian, who carried many responsibilities in Dalian for ensuring the smooth organization of the meeting; Chen Xingdong and Su Guoli of the World Bank's Resident Mission in China, for all their liaison work and logistical support; and finally, Ms. Meredith Dearborn, not only for secretarial assistance, but more particularly for editing the English translations of the Chinese papers. The conference was supported by a grant to the System Reform Commission from the Ministry of Finance under the World Bank Credit for the "China Reform, Institutional Support and Pre-Investment" project. Peter Harrold E.C. Hwa Lou Jiwei October, 1993 Shahid Javed Burki I OPENING REMARKS Shahid Javed Burki 1/ It gives me great pleasure to be with you here in Dalian for this conference on macroeconomic management in China. This is cosponsored by the World Bank and its two most important partners in China: the Ministry of Finance (MOF) is our host agency and our main interlocutor on lending issues; the System Reform Commission has long been our main collaborator in our dialogue on reform issues. Over the last eight years, we have held many conferences such as this one in collaboration with the System Reform Commission, as well as with MOF. On several occasions, these conferences have been held at critical points for the Chinese economy. For example, our conference on "Reform Priorities for the 1990s," in Hangzhou in October 1990, came just at the time when the momentum of reform was beginning to pick up once again after two years of rectification and adjustment. I feel that this is an equally timely conference. The most pressing question in China at the present time is the macroeconomic situation, and whether the present overheated condition of the economy is going to spill over into general inflation. Let us be clear at the start on that point: the issue is no longer whether the economy is overheated. As I indicated to Vice-Premier Zhu Rongji yesterday morning, there is no doubt in the minds of the World Bank experts that this is so, and is revealed in particular by the pressure on raw materials markets and by the rapid growth of demand for imports and slow growth of exports. Money supply is continuing to grow at very high levels indeed, and it is only a matter of time before these pressures spill over into higher rates of price increase for final goods. It is the World Bank's view that it is still possible to avoid a "hard landing" for the economy, if sufficiently strong actions are taken soon. I hope at the conclusion of these deliberations that we will be able to offer some policy suggestions to China's senior leaders to restore macroeconomic balance to the economy. Vice-Premier Zhu said yesterday that the government has already taken some measures to cool off the economy. We do not think that the measures that have been taken to date are sufficient. The very low increase in lending interest rates is not good for the banking system. Action to raise the interest rate further is the first thing that we would emphasize for the short term. This should be followed by measures to bring greater depth to foreign exchange markets, and by an early start to the deeper reforms of the monetary system, especially the regulatory functions of the central bank. It is therefore our hope that the recent measures will soon be followed up by deeper actions. I/ Shahid Javed Burki is Director, China and Mongolia Department, The World Bank. 2 Opening Remarks The fact that the economy is overheated is symptomatic of the imperfect development of the instruments of indirect economic management in China, and of the absence of adequate tools for macroeconomic management. Therefore, we should attempt to look beyond the difficulties of the short term and focus on what has to be done over the medium term to prevent them from recurring every few years. This is why this conference is so timely, for the present economic situation adds urgency to what we have to discuss. It is my hope that by the end of these three days, we can reach a collective set of recommendations to present to China's senior leaders for the reforms that should be instituted in this area. It will not be enough for us just to have an interesting exchange of views on these topics, as often occurs at these conferences: this time we must draw up an agenda for action for structural reforms that would obviate the need for periodic resort to extraordinary measures to bring balance to the economy. There are many issues that we will address this week. I want to note four in particular that I consider to be especially important. First, one key question that has yet to be resolved in China is the creation of institutions and then promoting their development for the coordination of macroeconomic policy-making. It is not practical for the State Council to do this itself: it needs an official agency to be responsible for providing it with analysis and recommendations, especially when it comes to, for example, conflicts between monetary and fiscal policy. This question was not addressed by the initial round of the government reorganization, and I hope this is a topic that we can address this week, and at least agree that it is something that needs to be resolved. Second, I want to stress that it is no accident that this conference is cosponsored by the Ministry of Finance. Fiscal policy has as yet played very little role in resolving the current difficulties, and I well recall that in the crisis in 1988, fiscal policy made very little contribution to solving the problems. The reason for this is clear: the present fiscal system is both technically and politically very inflexible, and it is not able to respond to short-term problems. The system continues to rely very heavily on state- owned industries as the primary source of revenue, and the method of tax collection leads to a range of problems that are well-known to you. Many economists and policymakers are very aware of these issues, and the World Bank and others have had many conversations on these questions over the years. However, tax reform and budget revisions have continued to take a back seat on the policy agenda. It is now time to place fiscal reform at the very center of reform efforts. I hope that this conference will define a set of priorities in this field. In this regard, I want to note that the recent experiments in tax reform do not seem to be at all well-designed, and do not seem to be yielding very positive results. This may prove to be an area of reform where the traditional reform method of having a regional experiment followed by general application may not work, and instead it may be necessary to define the reform program, and then implement it gradually, as fiscal and enterprise contracts expire. Indeed, it may well be that in the area of macroeconomic reform in general, a new reform style will have to be defined, and this bears examination this week. Shahid Javed Burki 3 Let me touch on two more areas briefly. First, we have held many discussions in the area of financial sector reform over recent years. It is my belief that we are now very much closer to an understanding of what has to be done, and that it is the technicalities rather than the principles that are yet to be resolved. However, the recent economic situation has further emphasized the case for a stronger central bank, and the passage of an appropriate Banking Law is perhaps the single most important step that we can recommend in this area. Finally, I want to urge something that may seem to some of you to be controversial, but which we would put very close to the top of the agenda at the moment. Provided that you are able to impose some discipline on monetary expansion, this would be an ideal time in our view to launch an aggressive program of import liberalization by relaxation of restrictions and by tariff reduction and simplification. This would contribute in a very significant way to the creation of the market economy by generating more competition for the state-owned sector; it would encourage the continuation of foreign direct investment; and it would help to overcome the present overheating and remove the threat of inflation. Imports can help to meet the growing demand in the economy, and act as a safety valve for future demand expansion. Moreover, with the present very high level of foreign exchange reserves, a trade deficit would help to slow down the growth of the money supply, which is so worrying. I would like to stress that these are the reasons for import liberalization, rather than the goal of entering GATT, and I hope that this conference will be able to agree on this issue and urge action in this area in the near future. Of course, this will require accompanying reforms in the foreign exchange regime, which has been such an irritant of late, and this we should address at the same time. It would seem to me to be appropriate to recommend an early reform of the foreign exchange quota retention system, and movement towards unification of the exchange rates. While I have defined an ambitious agenda, I am fully aware of the fact that we just do not have the time to do justice to all the items I have listed above. We need to prioritize our work in the next two and a half days. My own strong preference is to concentrate our attention on the policies that would help the Chinese authorities to restore economic balance and to dampen once and for all the fluctuations that have marred an otherwise impressive performance since reforms began in 1978. In my view, we would have accomplished a great deal if we are able to achieve two things here at Dalian. (a) Identify the policies the government needs to adopt immediately to cure an overheated economy. (b) Identify an agenda for the structural reform of the Chinese economy and its institutions over the medium term. Guo Shuqing 5 DEVELOPING CHINA'S MACROECONOMIC MANAGEMENT Guo Shuqing 1/ A. INTRODUCTION It has been less than a decade since the term macroeconomic management gained popularity in China's economic circles. However, today it is more frequently used in China by government officials, entrepreneurs and economists than in any other country. What this could mean is that people often use the term in a very broad or even confusing way. This is hardly surprising. Under the 30-year-old planned economy system, China's economy was under highly centralized administrative control, which is referred to as the "grand unified economy." Neither independent micromechanisms nor independent macromechanisms existed. China's economic reform is a constant process of separating the micro- and macromechanisms from each other, a process which is still evolving. However, China's economic reform has entered into a mid-term and maturity period, with the explicit goal of developing a socialist market economy system. Commodities have basically been marketized and production factors are going to be completely marketized. With the nonstate economic sector growing increasingly stronger thanks to market competition, it has become urgent for the government to change its functions and means of managing the economy. Against this background, it is necessary for us to study seriously and clarify the implications of macroeconomic management and thus provide the needed orientation for the development of China's macroeconomic management. B. MACROECONOMIC MANAGEMENT-GENERAL DEFINITON The following discussion takes place in the context of a general market economy. Such being the case, we cannot ignore the fact that the practices and theories of macroeconomic management derive from Western countries. Nonetheless, even in Western economic literature, it does not appear easy to find a precise and explicit definition for macroeconomic management. A view that is probably acceptable to most economists is that macroeconomic management should not just be equated as government's management of the economy. The government involves itself in the economy in many ways; hence, it manages the economy in numerous ways. For instance, the government should maintain order of the market economy, ensure fair competition through legislative and law enforcement means and through administrative supervision. It is responsible for building and managing public facilities and utilities. It should keep a watchful eye on the financial state of state-owned enterprises and ensure that the value of state-owned assets is protected and increased. In addition, social services directly provided by the government can also be regarded as a special economic sector. These economic activities I/ Guo Shuqing is a research fellow at the Center for Economic Research of the State Planning Commission. 6 Developing China's Macroeconomic Management or economic-related behavior of the government should not be regarded as macroeconomic management. What kind of government functions does macroeconomic management then consist of? For a long time, economists have held that macroeconomic management means the regulation of aggregate economic activities, such as total consumption, national savings, total investment as well as the amount of money supply, budgetary revenue and expenditure, balance of payments, etc. The experience of some countries, however, has shown that, in addition to the aggregate, the government should also focus its attention on the industrial structure, a key issue since the market is not a perfect one in real life. It is noteworthy that the industrial policies adopted by Japan and the Republic of Korea have enabled them to achieve world-renowned economic progress. Some economists also hold that income distribution should not be neglected by government macroregulation since it has distinctive socioeconomic dimensions. The governments of many countries have indeed regarded income policy as a part of macroregulation. To regard macroeconomic management as just aggregate management is, in fact, to equate aggregate management with management of total demand. As seen by many economists, a planned economy is a type of resource-constrained economy, whereas a market economy is a demand-constrained economy. Therefore, the macroregulation of a market economy is also regulation of demand. It is just the total demand that is influenced by what are known as monetary and fiscal policy. Yet, actual economic performance has shown that while a market economy is often faced with the pressure of insufficient demand, if the stimulation of demand alone is adopted as the macropolicy to check depression and crisis, it could eventually lead to stagflation, namely, inflation coupled with economic stagnation. Viewed from another angle, supply and demand, theoretically speaking, cannot be completely separated from each other. While demand may spur supply, supply can also create demand. Thus, more economists today would consider that macroeconomic management is not just the management of demand, but of both demand and supply. Not unrelated to the above, what traditional macroeconomic theory and practices have demanded from macroeconomic management is short-term economic stability and equilibrium to the exclusion of long-term economic development. However, as far as the developing market-economy countries are concerned, it is the unavoidable responsibility of government to provide a long-term development strategy and guidance. And these governments will naturally believe that it could perhaps be more important to ensure long-term sustained high growth than to curb short-term economic fluctuation. What is more, even in a developed country, not to study and consider long-term development trends and adopt corresponding policies will entail undesired consequences. It therefore seems that more and more people would agree that macroeconomic management should concern itself with both short- and long-term economic problems. In view of the above, macroeconomic management could perhaps be defined as follows: to adopt policy measures on various issues that bear upon the overall economic situation so as to advance stable, balanced and effective growth of the economy. Guo Shuqing 7 C. TiE SPECIAL NATURE OF MACROECONOMIC MANAGEMENT IN CHINA TODAY Full account must be given to the special nature of China's economy in constructing and exercising macroeconomic management. In the first place, China is a developing country that practiced an administratively controlled economy for over three decades. Thanks to the reform and opening-up program introduced in the past decade and more, China's economy has seen tremendous changes. Still, a dual economy, bottleneck constraints and a low degree of monetization that are common to the undeveloped economy remain the basic features of China's economy. What is more, China's economy is quite different from that of other developing countries. For example, the percentage of processing industries in the economy is rather high, yet that of the service sector is extremely low. What is more extraordinary is that China's industry covers the full range from the most primitive mode of production to the most sophisticated industry, which is truly unique. Second, China's economy is that of a big country. It has the largest population in the world. In the course of developing a market economy in such a large country, one is bound to encounter the contradiction between a regional market and a national market, the grave imbalances in the level of development among different regions and the issue of how to handle the relationship between the central and local governments. Third, what is particularly unique is that China's economy today is experiencing structural transformation from a traditional planned economy to a market economy. The experience of both China and the East European countries has shown that this is not something that can be achieved overnight. Although China has made much headway, its economic structure will, for a fairly long period of time, be transitional in nature. These three special features have determined that China's macroeconomic management will necessarily be different from that of other countries. Even compared with undeveloped countries possessing a market economy, China must, in exercising macroeconomic management, pay special attention to structural adjustment while laying emphasis on the total aggregate relationship, maintain a long-term perspective while tackling short-term problems and use structural reform as a crucial key variable when making full use of various policy means. D. THE GENERAL SCOPE OF CHINA'S CURRENT STAGE OF MACROECONOMIC MANAGEMENT Like other countries, China gives top priority to bringing about short-term aggregate equilibrium in exercising macroeconomic management. However, China's current annual aggregate regulation lacks an explicit quantitative definition, which is generally defined as maintaining the basic balance between aggregate supply and aggregate demand. Yet in the economic literature of most Western countries, aggregate supply and aggregate demand are automatically and permanently balanced with each other. What happens in China is that the newly increased inventory, an important variable, is not given 8 Developing China's Macroeconomic Management due regard in China's statistical and planned management system. Our proposal is that the goal of short-term aggregate management should be to bring about equilibrium between effective demand and potential supply. A similar and more popular way to put it is that consumption and investment should be maintained at a level that can be sustained by China's economy. Although decisionmakers stress the importance of increasing supply, the macropolicy actually pursued seems to be more geared to regulating demand. Currently, the most closely followed variables are the scale of fixed capital investment, the amount of bank loans issued and the balance between imports and exports. Yet, much is left to be desired in determining the reasonable quantitative indices of these variables. What is done is to just take the respective figures of last year as the base, adjust it as one sees fit (this is normally done by adding a figure), and then pursue them as planned goals. Actually, these variables are interlinked. The relationship between them is clearly indicated in the equation that national savings = investment + net exports. However, it was not until 1992 that people began to appreciate and use the concept of national savings. And the term is still not incorporated into the current economic statistical accounting system. What is more, the banking credit scale index is not as relevant as the index of money supply. However, what is a reasonable supply of money remains a controversy. A popular view holds that the growth rate of the money supply should be the economic growth rate plus the expected rate of price increases. Yet this view neglects a very important factor, that is, the process of monetization in a developing country. The balance of payments occupies a special place in short-term management. The balance of payments means that there must be a complete balance of revenue and expenditure of the unified current account and capital account. Strangely, in China excessive attention is paid to the current account, to the neglect of the capital account. To ensure a balance of payments, China still exercises administrative control over the use of foreign exchange in foreign trade. People tend to be very concerned with the deficit in the current account but pay no attention at all to the deficit in the capital account (the net capital outflow). As we see it, a rational structure of the balance of payments in China today should be just the opposite. China does need and can adopt an effective long-term development strategy. This is of key importance to a large and populous country whose infant market mechanism is just emerging. Starting from 1979, China has freed itself from the traditional model of development, shifting the focus of its development from heavy industry to consumer industry and agriculture, with the latter spurring the development of the former; from import substitution to both export promotion and import substitution; and from state accumulation only to accumulation by many sectors. Facilitated by the sustained reform and opening-up program, the new development strategy has achieved great success, and the strategic goal of doubling the gross national product in a decade has been fully met. China entered into a new stage of development in the 1990s. The low level of national income has risen to the medium level, namely, from "meeting people's basic needs" to "attaining a generally well-off status". We are faced with the task of speeding Guo Shuqing 9 up development of infrastructure and basic industries, easing the bottleneck constraints, rapidly expanding the service sector and upgrading the overall technical level of industry and agriculture. This calls for, in addition to the continued development of competitive, labor-intensive industries, the accelerated development of capital- and technology-intensive industries and of rural urbanization, as well a closer integration between information- oriented development and industrialization. Further deepening of reform and expanding the open-door program are essential for achieving the above strategic goals. We are bound to meet many new challenges in carrying out this development strategy. It will not do just to follow the practices of the 1980s, since China's economic operating mechanism has gone through substantive changes, the degree of marketization is much higher than in the past and the whole economy is now much more closely geared to the international market. All these new trends are continuing to develop. A development strategy not taking into account these new developments will be nothing but empty policy slogans. Employment is often a target of short-term macroregulation in the West; however, it could be long term in nature in China. China's economy is basically an economy with serious invisible unemployment. At least one third of the labor force in industry and particularly in agriculture is redundant. To turn such invisible unemployment into open unemployment is more than the society can stand. What should be done is to speed up economic development and thus create more sectors and job opportunities. This has proved feasible in practice. China has always placed importance on the policies concerning industrial structure in both short- and long-term macroeconomic management. We have both successes and lessons in this regard. Because of the influence of the traditional planned economy over the years, we tend to be comprehensive in adopting and implementing industrial policies. The result is an all-embracing policy-oriented plan, which is in conflict with the basic orientation of reform and opening-up. Another important lesson is that we were rather eager to learn from the experience of Japan and the Republic of Korea, yet forgot that the basic context is different. The Japanese and Korean firms are not state- owned enterprises as under our system. Despite this, we still hold that regulation of the industrial structure is an indispensable component of macroeconomic management in the 1990s. Provided past lessons are taken into account and practices are changed, industrial policy can be pursued in an effective way. Income distribution is also an area that cannot be ignored in exercising macroeconomic management during the current stage. Since the reform and opening-up program got under way, we have always used control of the wage level as an important means to curb inflation and price increases. We also hope that at the same time as abolition of egalitarian income distribution, we can limit or eliminate unfair distribution of income resulting from unequal conditions of competition. Provided that distribution of income is conducted in accordance with the principle of "to each according to his ability" and that the production factors are properly distributed, some people are allowed to get rich ahead of others while common prosperity should be ensured. In some rural areas with developed township industries, the distribution of income is fair enough. Yet the overall situation leaves much to be desired. On the one hand, egalitarian income distribution is 10 Developing China's Macroeconomic Management still the trend in many state-owned enterprises, government departments and some collective enterprises, with the growth of wages and welfare benefits outpacing that of economic growth. On the other hand, prevalent "rent-seeking," a product of the "dual- track" structure that hunts for nonbusiness profit, has occurred throughout the country. Unfair income distribution has hindered the improvement of economic performance and is bound to give rise to certain social problems. Another issue of common concern to economists is that the uneven level of development among regions has caused their income gap to widen. While we should not try to narrow the gap by simply transferring income from the rich regions to the poor, neither can we allow the situation to develop unchecked. We are now faced with a choice in concrete quantitative terms. In addition to the above, China's government departments also maintain the power to control and intervene in the business operation of enterprises and particularly the state-owned enterprises, such as the power to appoint and dismiss factory mangers and to approve the negotiated management contract. Yet, these functions should not be regarded as that of macroeconomic management. However, to maintain and improve the economic order and particularly the market order is the undeniable responsibility of macroeconomic management during the current stage. In a mature market economy, the economic order is primarily maintained by means of laws, contracts, customs and ethics. Yet in China, which is going through structural reform, competent government departments have to have certain administrative means to supervise market activities, which makes it even more necessary to speed up the development of a legal framework. E. THE ACTUAL EXERCISE OF CURRENT MACROECONOMIC MANAGEMENT AND EXISTING PROBLEMS Experience of the past decade or so has shown that in the course of exercising macroeconomic management, one often encounters a major problem, that is, economic growth and structural reform may require conflicting macropolicy guidelines. In terms of theory, reform should receive priority consideration since it promotes long- term development. Yet in reality, people are reluctant to sacrifice short-term interests and are unwilling to give up any economic returns that are just within reach. A more difficult issue in this regard is that to attain a particular goal of macroregulation, one needs both general policy means and reform measures as specific policy means. The adoption of both kinds of policy means has proved quite successful, particularly in adjusting the industrial structure and in balancing payments, both internally and externally. An issue that is hard to handle when using means of macroregulation is how to properly balance the use of direct control and indirect control. As the economic structure needs to change and is in fact constantly changing, this issue is even more difficult to deal with. The academic and business communities always appeal for more Guo Shuqing 11 indirect control, whereas the government, knowingly or unknowingly, tends to favor the use of direct control. And both approaches probably might be one-sided in nature. Things have greatly changed. Whether people have realized it or not, direct plan or administrative orders concerning the production and marketing of commodities as well as investment have, in the majority of cases, become ineffective. For the government to influence the economy, the only major means available to it are loans and credit, budget, taxation, as well as other means based on the monopoly of production factors such as interest rates, exchange rates, land rent and approval of issuing securities and of imports and exports. Viewed from this perspective, China's macroeconomic management has, to a greater extent, become indirect in nature. In the case of demand management, the issuance of coupons for the purchase of consumption items, such as grain and cooking oil, by individuals has almost been abolished. The approval procedures for controlling the purchase of consumer items by government departments and enterprises more or less remains something on paper. Regional and sectoral control over the scale of investment in fixed assets still exists, and government approval is still required before a construction project can be undertaken whose investment has exceeded certain limits. But in reality, such control and approval procedures are rarely heeded and in many cases simply ignored. The highly administrative means adopted to regulate wages and other individual income have proved unsuccessful. The state-owned enterprises, which are under the tightest control, are required not to increase wages for employees faster than the growth of profit, tax delivery and labor productivity. What has happened is that the former grows much faster than the latter. In terms of supply and structure, direct control is even less satisfactory. Plans and policies call for giving priority consideration to the development of bottleneck sectors and of large and medium enterprises with sound economic scales. Despite the measures taken, these sectors and enterprises have performed poorly economically. It is those enterprises not covered by plans that have grown fastest. Similarly, it has proved very difficult to limit the growth of the sectors and enterprises whose products are in excess supply and to reduce the inventory. By 1992, unmarketable products produced by state-owned enterprises had reached several dozen billion yuan. How have these indirect means performed when direct control has increasingly lost effectiveness? The situation is hardly reassuring. The government finance and tax collection procedures, not having been fundamentally reformed, can only play a very marginal role in regulating the economy, with government finance having little room for expansion or contraction and the tax collection system too complex and outdated to play a regulatory role. It is true that progress has been made in the field of foreign trade and foreign exchange. However, as nonstandard measures have been adopted, irregularities have frequently occurred, and the overall performance is far from satisfactory. Confusion in the collection of customs duties and in foreign exchange regulation are cases in point. 12 Developing China's Macroeconomic Management A profound change that has escaped people's attention has occurred in the monetary field, a most important means by which the government exercises macroregulation. The government credit plans used to cover or dominate the entire monetary sector. Since the reform and opening-up drive was launched, monetary activities other than bank loans have emerged. Public financing of various forms has steadily expanded. In the last couple of years or so, securities and trust investment have seen explosive growth. The issuance of securities still requires prior government approval and is supposed to be incorporated into the government plan. However, because of a lack of strict enforcement means and particularly because the local governments are driven by the interests of local development, government control is rather weak. There are also loopholes in bank issuance of loans. Out of self-interest or under pressure from local governments, the specialized banks vie with one another in issuing loans. It is common knowledge that the government-imposed loan issuance ceilings are often exceeded or ignored. As the old economic structure was one of administrative command in nature, it was highly dependent on direct control and government management. While market mechanisms have been introduced and decision-making powers delegated to enterprises since reform began, overall management of the national economy to a large extent is implemented through the government system, and this is particularly true when drastic fluctuations occurred in the macroeconomy. It is thus natural that the view has emerged that macroeconomic management should be conducted on separate levels, a view that is in fact practiced. However, as the economic functioning described shows, the local governments are no longer in a position to play a positive role of macroeconomic management. It is now neither possible nor necessary to demand that local governments be responsible for retail price increases, investment scale control, level of interest rate, issuance of loans and average wage level. It is true that local governments still play a major role in regulating the regional investment structure. Yet people have questioned whether such a role is positive or negative. Local governments also need to spend a lot of time supervising agriculture and promoting marketization of the rural economy. However, as far as macroeconomic management in terms of the protective prices of agricultural products and the reserve system is concerned, the job can obviously be better handled by central government agencies. In short, it seems that the time has come to make it thoroughly clear that macroeconomic management should be the responsibility of the central government and to end in not too long a period of time existing macroeconomic management on separate levels. This does not mean that local governments should be deprived of their economic functions. On the contrary, our goal is to enable the local governments to better perform the economic functions due to them, such as developing the infrastructure, improving the investment environment and managing well their own budgets and various undertakings. F. FURTHER REFORM OF CHINA'S MACROECONOMIC MANAGEMENT To maintain the current macroeconomic management system without reforming it in a fundamental way will create huge problems for the stable development Guo Shuqing 13 of China's economy. It is urgent that its macroeconomic management be reformed in order to speed up the development of a market economy system. The direction for further reform is a clear one. In light of the need for a developing market economy and particularly the need for marketizing production factors in the current stage, it is necessary to improve the means and mechanisms of macroregulation, to abolish the outmoded means of direct control and to enhance and improve means of indirect control. Assisted by accelerated marketization of factors of production and reform of the operating mechanisms of state-owned enterprises, we should adopt the following steps in the near term to reform the macroeconomic management system: (a) The organizational setup of macroeconomic management should be unified. The respective functions of competent government agencies and coordination among them should be clearly defined. An end should be put to the current lack of coordination and diffusion of functions. (b) The respective functions of financial budget and bank loans should be strictly separated from each other. Expenditures that should be covered by the government budget should not be paid by borrowing money. To reduce the budget deficit, the increased issuance of treasury bills may be considered. More borrowing of bank money for reducing the deficit or turning over the deficit to a bank account should not be allowed. (c) Government finance should free itself from the notion of "construction financing." As a matter of principle, government finance does not have to provide funding support to general industries and basic industries. The financing of infrastructure should be handled on a case-by-case basis. Government finance should only provide funding support to infrastructure that cannot be developed and operated on a commercial basis. On the other hand, the size of expenditures on public undertakings and of debt should be handled in a more flexible manner and adjusted in accordance with development of the economy under the government budget. There should be separate tax collection systems for the central government and local governments on the basis of separation of powers and responsibilities. The local governments must subject themselves to the supervision of central government finance agencies in collecting taxes and issuing bonds. (d) It is necessary to increase the value-added tax, unify the enterprise income tax and introduce a standard and unified individual income tax so that taxation will be in step with the drastically changed pattern of national income distribution and play its due role as an important means of macroeconomic management. 14 Developing China's Macroeconomic Management (e) Policy-oriented and commercially oriented financial institutions should be separated from each other. The policy-oriented financial institution should not fall into the beaten track of turning itself into a government finance agency in disguised form by changing budgetary appropriation into loans. It should also undertake risks and bear responsibility. (f) The role of the central bank should be enhanced. It should not engage in activities that are commercial banking in nature. Its representative agencies should not continue to be set up on the basis of administrative jurisdiction and ranks. The superfluous personnel may engage in other financial activities, but they must sever their ties with the central bank. (g) Monetary activities such as banking, insurance and securities investment should be strictly differentiated from one another. There should be rigid conditions attached for bank lending to enter into the securities and real estate markets to prevent any monetary crisis. (h) While maintaining some necessary means of direct control (including administrative and moral suasion), efforts should be made to speed up the development of a mechanism for exercising indirect management over the monetary market. The money and capital markets should be further opened and the macromonetary management policies should be made more effective. (i) Foreign exchange control should be phased out so as to eliminate the artificial barriers in the supply and demand of foreign exchange. A unified foreign exchange market should be opened and the Renminbi turned into a convertible currency in China. (j) The scale of investment in fixed assets should be changed from a mandatory planned target into a forecast target for reference. Such means as monetary, fiscal, foreign investment and foreign trade policies should be used in concert to achieve equilibrium between national savings and effective investment. (k) The first issue to be addressed in improving the investment structure is to narrow the scope of government investment to infrastructure and public undertakings. Commercial investment should be made by enterprises themselves. The interregional and intersectoral barriers standing in the way of enterprise investment should be cleared. (1) The industrial policy, trade policy and development strategy should be based on macroforecasts and analysis of the market supply and demand relationship. The government should leave to the market what can best be handled by the market and only concern itself with what the market cannot accomplish, either inherently or for the time being. Lawrence Lau on Guo Shuqing 15 COMMENT ON "DEVELOPING CHINA'S MACROECONOMIC MANAGEMENT" by GUO SHUQING Lawrence J. Lau 1/ A. INTRODUCTION Professor Guo Shuqing has provided us with a very useful blueprint for the reform and development of the macroeconomic management system in China. Professor Guo begins with an excellent definition of macroeconomic management: it is the formulation, adoption and implementation of "policy measures ... that bear on the overall economic situation so as to advance the stable, balanced and effective growth of the economy" (italics mine). This definition encompasses both the short-term stabilization and the long-term balanced growth aspects of the objectives of macroeconomic management.2/ Professor Guo differentiates between the supply side and the demand side. A market economy is by definition a supply and demand-constrained economy. I agree with Professor Guo's view that the task of macroeconomic management is the management of both aggregate demand and aggregate supply. The short-term objective is to avoid either an excess or a deficiency in aggregate demand. The long-term objective is to increase aggregate supply. Aggregate supply can be increased through an increase in the inputs, capital and labor, or through a more efficient utilization of the existing inputs (which we take to include what economists define as technical progress), or both. The development experiences of the industrialized and newly industrialized countries suggest that the most important source of economic growth for a country at China's stage of development is efficient capital accumulation-the combination of a high rate of gross fixed investment with its efficient allocation and utilization. Aggregate demand and supply are, however, also interrelated. While excess aggregate demand can stimulate supply, increases in aggregate supply often create their own demands. Thus, simultaneous, coordinated expansions can sometimes succeed when 1/ The author is Kwoh-Ting Li Professor of Economic Development, Department of Economics, Stanford University. 2/ Macroeconomic policy measures may have significant impacts on the distribution of income, which in turn may affect the rate and stability of economic growth. These impacts must be taken into account in the evaluation of alternative macroeconomic policy measures. However, macroeconomic policy measures are themselves a very blunt instrument for affecting the distribution of income. A more targeted approach is often needed if an equitable distribution of income is a direct objective. 16 Comment uncoordinated individual expansions fail, especially when significant economies of scale are present at the enterprise or plant level.3/ Macroeconomic management has become an increasingly important way to control the Chinese economy because the proportion of the economy subject to direct administrative control has diminished sharply; and even within that portion of the economy, the control has often not worked. Professor Guo has brought up the important distinction between direct and indirect control. Indirect control works through the markets, through changes in the prices of resources (including capital, credit and foreign exchange). By contrast, direct control is exercised in the form of quantitative targets enforced through administrative channels. Western economists generally favor indirect control, but the effectiveness of indirect control is predicated on the supposed behavior of enterprises and households-that they respond to incentives, positive and negative. In a mixed, transitional economy such as China's, the behavior of some enterprises, particularly the state-owned ones, and households may be quite different from that expected of similar enterprises and households in market economies. Hence, the traditional instruments of macroeconomic management may have little or no impact on the behavior of some enterprises and households and be ineffective in controlling the economy. Indirect control must therefore be supplemented with direct control in the macroeconomic management of China at its current stage of economic development. B. THE LINK BETWEEN SHORT-TERM STABILIZATION AND LONG-TERM GROWTH Long-term growth depends on the expansion of productive capacity and capability, which in turn depends on continual investments in plant and equipment, in the infrastructure, in human capital, and in R&D. The last three categories of investments, in particular, require patient, steady, long-term efforts. These days everyone is impressed with the economic performance of the "Four Little Dragons"-Hong Kong, Singapore, the Republic of Korea and Taiwan (China). However, what is not so well known is that more than three quarters of the economic growth in these economies may be attributed to the growth in their capital stocks.4/ This underlines the critical importance of capital accumulation in economic growth. However, with a national saving rate approaching 40 percent, the problem with the Chinese economy is not so much a shortage of investment, but the low efficiency of the investment, resulting in a low marginal productivity of capital. The major challenge for the Chinese Government, therefore, is not how to increase the saving rate, but how to raise the efficiency of investment. The objective should be to maximize the returns from the new resources. 3/ For example, with simultaneous expansion, the workers of the different enterprises will have wage incomes to purchase the outputs of one another's enterprises. The enterprises themselves will have the income to purchase capital goods from among themselves. Of course, this works only if the scale of the economy is large enough so that the minimum efficient plant scales can be attained. 4/ See J.-I. Kim and L. J. Lau, "Sources of Economic Growth of Newly Industrialized Countries on the Pacific Rim," Working Paper, Department of Economics, Stanford University, May 1992. Lawrence Lau on Guo Shuqing 17 Why is it important for long-term growth to maintain short-term stability in the economy? It is because a boom-and-bust cycle results in significant waste in resources. During boom times, many projects are left incomplete and not put into productive use. During times of recession, much of the plant and equipment remain idle. Moreover, many of the investment projects undertaken in the heat of a boom eventually turn out to be uneconomic investments and do not augment the aggregate productive potential of the economy at all. Instability also breeds uncertainty, and uncertainty discourages investment, especially long-term investment. A persistently high rate of inflation also affects the nature of the investment; for example, it favors land speculation and speculative trading over the establishment of new, employment-creating ventures. Inflation also creates the need for continuous devaluation of the currency in order that exports can remain competitive. Continuous devaluation in turn discourages foreign investment, encourages capital flight and currency speculation, and feeds back on inflation itself. While inflation per se can be an effective taxing device for a large developing country such as China, it has major adverse side effects: it discourages saving; it creates inequities; and it sets up the wrong incentives by rewarding short-term speculators and hoarders and penalizing investors in projects with long gestation periods. The basic difficulty of an unstable macroeconomic environment is that it reduces both the quantity of productive investment and its efficiency, resulting ultimately in a lower rate of economic growth. Both inflation and unemployment create social problems by worsening the distribution of income. Growth contributes to stability by making it possible for everyone in the economy to be better off even as changes occur, thus keeping the people hopeful and secure, and therefore more cooperative and less risk-averse. Stability and growth are therefore complementary in the long run. C. GOALS, INDICATORS AND INSTRUMENTS OF MACROECONOMIC MANAGEMENT What is the goal of macroeconomic management? Professor Guo has stated it very well: the stable, balanced and effective growth of the economy. Stabilization implies not only the control of inflation but also the reduction in the fluctuation of the rate of economic growth and employment over time. Balance implies the elimination of bottlenecks 5/ and the efficient allocation of investments across sectors (and regions). Balance also implies the maintenance of an acceptably equitable income distribution, which in turn contributes to stability. Growth depends on capital accumulation (and at this stage of the development of the Chinese economy, mostly tangible capital accumulation) and its efficient utilization. What are some reliable indicators of successful macroeconomic management? In other words, how does the government know whether it has been doing a good or poor job of macroeconomic management? The traditional performance indicators, linked directly to the objectives of economic growth-unemployment, inflation and the distribution of income (e.g., the Gini coefficient)-are of course still relevant. However, an indicator such as the rate of growth of the money supply is not a particularly Sl When growth is truly balanced, and resources are fully utilized, every sector is a bottleneck sector. 18 Comment good indicator of the degree of tightness or slack in the Chinese economy. It is not so much that the quantity equation (PV= MT) does not hold for the Chinese economy but that the velocity of money has been undergoing autonomous changes as a result of the rapid transformations of the institutional, organizational and ownership structures, manifested in the form of an increasing degree of monetization, in the economy. It may thus be perfectly normal for an economy in transition such as the Chinese that the demand for the money supply to grow significantly faster than the real GNP, even with the price level remaining constant. The "supernormal" demand for money originates from a variety of sources: the increasing marketization of real transactions as a result of specialization and division of labor; the increasing monetization of real assets, e.g., land and real estate, many of which have been carried on the books of enterprises at essentially zero cost hithertofore; and the increase in purely financial transactions (such as the trading of shares among existing shareholders). Thus, the total volume of transactions, including purely financial ones, at any given level of prices, has been rising relative to the volume of real economic activities. Hence, the excess of the rate of growth of the money supply (or demand), over the sum of the rate of inflation and the rate of growth of the real GDP, no longer reliably indicates, by itself, whether and by how much the economy is overheated. For this reason, and given that (1) the market does not work perfectly and (2) significant direct controls still exist in the Chinese economy, the behavior of other technical indicators, such as prices of key commodities like steel and cement, and their inventory levels, may be far more informative. Another important indicator is the industrial consumption of electricity relative to the peak generation capacity. What can also be useful is the "black market" rate of interest-the rate at which nonstate-owned enterprises can obtain credit on the informal money market. If the rate of inflation is expected to accelerate, the nominal "market" rate of interest will rise. In the Chinese economy, the closest thing to a "market" rate of interest is the "black market" rate mutually accepted by willing lenders and borrowers.6/ What should be done to prevent the overheating and to moderate the boom or bust cycles that have become characteristic of recent Chinese economic development? The traditional remedy is to tighten up the money supply, both in terms of currency in circulation and in terms of demand deposits (the latter through a reduction of bank lending). While the money supply should indeed be carefully monitored, the difficulty of actually implementing the traditional remedy is that no one really knows very precisely by how much the money supply should be tightened. It is thus not useful to adopt a simple monetary target.7/ Instead, one should use a real interest rate target, and set monetary policy to maintain the real rate of interest within a relatively narrow, positive range.&/ 6/ The implied yields of government notes and bonds on the secondary market can also be a good indicator of the nominal "market" rate of interest. I owe this point to Dr. Pieter Bottelier. 2/ Recent experience suggests that this rule has also proved not to be very useful in industrialized countries, such as Germany, the United Kingdom and the United States. 8/ A real rate of interest of 3 percent per annum, plus or minus 1 percent, seems reasonable by Chinese historical standards. Lawrence Lau on Guo Shuqing 19 Operationally, targeting the real rate of interest can work in the following way. The nominal rate of interest on savings deposits can either be indexed to the consumer price index, or be set at, say, 3 percent above the rate of growth of the consumer price index. The nominal rate of interest on loans to enterprises can be set a little higher, say by at least 0.5 percent, than the nominal rate of interest on savings deposits. (Thus the banking system will not make a loss on its loans 9/ and, therefore, will not have to eventually print more money to cover these losses, adding to the inflationary pressure.) However, raising the rate of interest alone, while it may deter the joint venture, township and private enterprises from borrowing, is not likely to deter state- owned enterprises. 10/ More direct controls are necessary. Bank lending for new investment, especially new investment by enterprises (as distinct from infrastructural investment), should be considerably curtailed if not suspended altogether as long as the rates of growth of the prices of the key commodities, such as steel and cement, remain high. The adjustments in the nominal rates of interest should be made often, and in small steps, to signal the resolve of the Central Government in preventing the economy from overheating. Small, frequent adjustments may also be compared to the smooth operation of a car. When driving a car, smooth acceleration and smooth braking provide a much more comfortable ride, save fuel, avoid accidents, and probably get one to the ultimate destination sooner. Controlling an economy works in much the same way. Other useful technical indicators include the exchange rate on the private (black) market, the prices of the outputs and the levels of unintended changes in inventory accumulation or decumulation for the aggregate economy and for key industries, backlogs of factories, rise and decline in small bank deposits, new job listings, job-wanted advertisements, new enterprise registrations, changes in the average age of accounts receivable, etc. These technical indicators, whether leading, coincidental, or lagging, can help identify the changing macroeconomic conditions much sooner and more dependably and determine whether, when and how to act. What are the available instruments? The available instruments include the traditional monetary and fiscal policy measures such as the money supply, the rate of interest, the exchange rate, taxes, expenditures, as well as more direct quantitative restrictions on credit, aggregate investment, and local government borrowing. Exchange rates and tax rates are not in general instruments that are suitable for short-term stabilization-they are too blunt as instruments. And quantitative restrictions are not in general easy to enforce-although they may have to be used, especially with respect to state-owned enterprises. One instrument that can be particularly flexible and may prove 2/ Of course, the banking system may still operate at a loss if it makes bad loans. 10/ This is due to the "soft budget constraint" of the state-owned enterprises. The incentives of the managers of the state-owned enterprises are not symmetric with respect to profit and loss. They have everything to gain if a new investment turns out to be successful, but little or nothing to lose if a new investment fails. This leads to overinvestment and to investments that cannot be justified on the basis of the expected rates of return. 20 Comment to be one of the most effective in the Chinese context, is the acceleration and deceleration of the rate of implementation of public infrastructure projects. By varying the speed of implementation of infrastructure projects over time and across locations, the government can take advantage of slacks in the economy and avoid periods (and regions) of artificially high prices and tight supplies caused by an overheated economy. This strategy also has the side benefit of improving the regional balance of economic development. D. MACROECONOMIC MANAGEMENT wrmI CHINESE CHARACTERISTICS The instruments and techniques available for the macroeconomic management of the Chinese economy as well as their effectiveness are different from those of the developed countries because of conditions peculiar to the Chinese economy. The Chinese economy is an economy in transition. Many of its institutions and practices are still evolving. The responsiveness of the Chinese economy to particular instruments may therefore be quite different from that expected of Western countries. The most important differences between China and developed countries of the West (including Japan) may be identified as follows: (a) A significant state-owned sector. This sector consists mainly of the enterprises owned in principle by "the whole people," but effectively by no one (except possibly the managers and the workers) of the enterprises. Since there is in effect no one to look after the interests of the "owners, these enterprises are not particularly responsive to incentives based on the profit-maximizing motive. Worse, they face a "soft budget constraint," which means that they have, or behave as if they have, an implicit guarantee of the state to make up any potential losses. This leads to investment behavior that borders on the reckless. The rate of interest, no matter how high, is not an effective deterrent to these enterprises in their investment decisions. Another implication of "no owners" is the prevalence of unauthorized distributions or other increases in compensation (sometimes in kind) to workers. Unless the behavior of these enterprises can be changed, or significantly altered (for example, by strictly limiting bank credit to finance working capital only), indirect macroeconomic management will be very difficult. (b) Chronic excess demand caused by excess investment. The macroeconomic imbalance in the Chinese economy is predominantly caused by excess aggregate demand rather than excess aggregate supply (the years in the immediate aftermath of the June 4 incident are exceptions). Moreover, the source of the excess aggregate demand is invariably excess aggregate investment. Thus, macroeconomic stabilization is almost impossible unless aggregate investment can be brought under control. (c) The changing velocity of circulation of money. The quantity theory of money plays an important role in the macroeconomic management of the developed countries of the West. However, as Professor Guo has pointed Lawrence Lau on Guo Shuqing 21 out: the rate of growth of the money supply is not simply equal to the rate of growth of the economy plus the expected rate of inflation. This is because of the changing velocity of circulation of money, even at a constant rate of interest, caused by the rising degree of marketization and monetization, the falling degree of vertical integration, the rising importance of the financial markets and of purely financial transactions (such as the buying and selling of shares); and changes in the institutions. 11/ All of this make the traditional rules for setting the money supply quite unreliable. (d) Poor infrastructure. The poor infrastructure and the resulting bottlenecks in energy, communication and transportation accentuate the macroeconomic imbalances. The poor infrastructure also contributes to regional disparities. For example, it is possible for one part of the country to be booming and for another part of the country to be in deep recession. (e) An underdeveloped system of taxation. Direct taxation of the incomes of individuals and households is not well developed. Even the direct taxation of the income of enterprises has only recently begun. There are no such automatic stabilizing features as a progressive income tax and social transfer payments linked to unemployment. The underdeveloped system of taxation constrains the effectiveness of changes in tax policy as instruments for stabilization and incentives for investment and growth. Increasing the Effectiveness of Macroeconomic Control One way of controlling the aggregate excess demand caused by excessive investment (and raising the efficiency of investment) is to prevent inefficient enterprises from undertaking new investment. If only efficient enterprises are allowed to make new investments, the average efficiency of new investment will be higher. The difficulty of implementing such a policy is that it is not straightforward to identify and separate efficient from inefficient enterprises, and even if it can be done, it may be politically infeasible to treat them differently. Instead, we can approach the problem from a different angle. We pose the question: What types of enterprises are more likely to have the incentive to operate efficiently and invest wisely? These are generally enterprises in which the management has to invest its own money and has a significant personal financial stake-so that it cares enough about losing money if the investment turns out to be a bad one. This description applies to joint venture, township and individual enterprises, but unfortunately does not apply to state-owned enterprises, with their well-known "soft budget constraints." The solution is, therefore, for the state to discontinue financing the new investments of state-owned enterprises whether directly through a budget allocation or indirectly through bank financing, or other forms of public borrowing explicitly or implicitly guaranteed by the state (with the possible exception of investments in pioneer industries). State-owned enterprises should be able to undertake new investments only if they can self-finance them 11/ For example, changing the period of account settlement, from say 60 days to 30 days, will increase the demand for money for transactions purposes. 22 Comment through retained earnings; that is, they must have been sufficiently efficient to have made some profits. We note that the state-owned enterprises are also the same enterprises that are not easily deterred by an increase in the rate of interest from making new investments. Thus, by not allowing unprofitable state-owned enterprises to make new investments, new resources will not be wasted. 12/ The Central Government, in turn, by concentrating its new investments in primarily the infrastructural areas, including energy and transportation, and in pioneer industries, can do more and at the same time avoid duplicating and competing with whatever other investments enterprises may wish to undertake on their own. The state-owned enterprises need and must be provided working (or circulating) capital financing. However, enterprises have been known to divert their working capital loan proceeds to finance unauthorized new investments and then return to the banks to request additional working capital financing. Banks cannot easily resist the political pressure brought on them, especially by the workers waiting to be paid. As a result, bank lending, as well as gross fixed investment, will greatly exceed the original targets. Such unauthorized new investment is a major reason for the overheating of the economy. Cutting off working capital loans completely is not a feasible option. The solution lies in the adoption of the so-called Real Bills doctrine of banking. Essentially, the "Real Bills" doctrine ties each working capital loan to its stated purpose in a very concrete way. For example, if an enterprise receives an order for its product, and needs working capital to purchase raw materials to manufacture the products to fill the order, it must first agree to assign the proceeds of the sale to the bank. The bank then will arrange to pay the raw material supplier directly upon delivery of the raw materials and hold the warehouse receipts. The raw materials will be released to the enterprise as needed for manufacture. When the products are shipped, the bank will collect the proceeds on behalf of the enterprise, deduct its share (the raw materials loan plus interest) and turn over only the balance to the enterprise. This way, the possibility of diversion of the working capital loan for the purpose of unauthorized new investment is minimized. It also, incidentally, provides some protection against the recurrence of the "triangular debt" problem as the bank can refuse to finance an order from an enterprise that is not financially sound. This procedure, while it may sound cumbersome, is actually quite standard in international trade transactions and should work quite smoothly after the requisite training of the bank personnel. In fact, it is not so different from that used by the Chinese banking system to monitor and control the enterprise's use of funds prior to the initiation of economic reform in 1979. 12/ This is essentially the policy pursued in Taiwan, China, beginning in the mid-1950s. State-owned enterprises were allowed to make new investments only in the area of infrastructure, including energy. Almost all other new industrial investments were made by private firms. China Steel Corporation, established in the 1970s, was a notable exception because it started out as a state-owned firm. However, this was mostly because of the withdrawal by many private investors in the aftermath of the first oil shock. See the discussion in L. J. Lau and D.-H. Song, "Growth versus Privatization-An Alternative Strategy to Reduce the Public Enterprise Sector: The Experiences of Taiwan and South Korea," Working Paper, Department of Economics, Stanford University, May 1992. Lawrence Lau on Guo Shuqing 23 Investing in Infrastructure A major reason for the high sensitivity of prices to excess aggregate demand and generally low efficiency of investment in China is the deficiency in its infrastructure. There are always serious bottlenecks in the energy and transportation sectors, particularly in boom years. Telecommunication is also underdeveloped in many areas. Appropriate investments in infrastructure can, therefore, greatly reduce the pressure on prices arising from the bottlenecks in the economy and enhance the rates of return of other investments, especially investments made by industrial enterprises. However, infrastructure investments are precisely the investments that most enterprises are unwilling or unable to undertake, or are willing to undertake only with a monopoly franchise. There is, therefore, a unique role for the Central Government to play. The Central Government should devote most of its investment resources to infrastructure investments and to refrain from investments that can be undertaken by enterprises on their own, state-owned or otherwise. The only noninfrastructure investments that the Central Government should undertake are those in pioneer industries, such as the manufacture of semiconductors, which can potentially generate large long-term benefits to the Chinese economy, but either are too risky or require too much capital for enterprises to undertake on their own. A side benefit of infrastructure investments is that they can be used to affect the location of industries and hence provincial and regional economic development. For example, with the proper transportation and communication facilities there is no reason why potential investors in certain light industries, such as textiles and shoes, will not wish to locate in Guizhou, where labor, land and possibly electricity are cheaper, rather than in the much more expensive Guangdong. Thus, infrastructure investments can be used by the Central Government as an instrument for redressing uneven regional economic development. A final benefit of infrastructure investments is that they can provide the necessary economic stimulus and help maintain full employment in an economic slowdown. Properly timed and phased, they can, through the postponement, or stretching out (slow down), but not necessarily the outright cancellation, of investment projects financed through the Central Government budget help smooth out the peaks and troughs of economic cycles as well as result in substantial real cost savings since the Central Government will be able to avoid the high prices during the boom times and take advantage of the lower prices during the slack period. However, in order for the Government to benefit from this possibility, it is important to have a catalog of on-the- shelf, ready-to-go infrastructure projects, each with multiple phases, that can be quickly activated in a time of economic slackness and just as easily deferred or suspended in a time of economic boom. Improving the System of Taxation For reasons of both short-term stabilization and long-term growth, it is highly desirable for the Central Government to find effective ways to raise revenue and to reduce current expenditure. In the short run, a higher revenue and a lower expenditure 24 Comment will result in a lower fiscal deficit and hence lower inflationary pressure on the economy. At the same time, more resources will be available to the Central Government for facilitating and guiding the long-term development of the Chinese economy through undertaking public infrastructure investment, broadly defined, including investments in communication, transportation, energy, education and research and development. The question is: Is it possible to find a taxation scheme that (1) raises significant new revenue; (2) grows with GNP and inflation; (3) is relatively easy to collect, that is, has low transactions costs; and (4) is broadly perceived to be "fair"? The traditional taxes, such as the income tax, the value-added tax, and the (final) sales tax, are all quite costly to administer and difficult to collect at the national (Central Government) level. In addition, for some of these taxes, a huge new administrative apparatus needs to be created. And voluntary tax compliance, never a Chinese tradition, is yet another problem that must be overcome. The net tax yields of these types of taxes, taking into account all of the costs of collection and enforcement, at the current stage of development of the Chinese economy, are therefore likely to be rather low in the near term. However, in the long run, only taxes with a broad base, such as the income tax, the value-added tax, or a consumption tax can generate the revenues needed by the Central Government. Several other, not mutually exclusive, new taxation schemes may also have applicability to the current Chinese situation: (1) an export tax combined with a simultaneous devaluation; (2) an energy tax; and (3) an indirect (commodity-based) consumption tax. These taxation schemes are discussed in turn. When it comes to the taxation of international trade, the first instinct, given the rapid increase in both Chinese exports and imports, is to impose a uniform tax on both exports and imports, as a fixed percentage of the value. Export and import taxes are difficult to evade completely 13/ because the great majority of the transactions have to go through both the banking system and the transportation system and hence can be easily identified. (That was one reason why the foreign powers elected to control the Chinese Maritime Customs as a way of assuring the payment of indemnities by the Qing Government.) The burden of export and import taxes will mostly be borne by the more well-to-do enterprises in the more well-to-do provinces, and indirectly, by their residents, since the major exporters and importers also happen to be the major beneficiaries of the export boom brought about by the open-door policy. It will thus be perceived as "fair" by the general public. As a practical matter, the most efficient way to implement such a tax is through a devaluation coupled with the imposition of only an export tax. (There is no need to impose an import tax directly, as explained below). A devaluation is always very popular with the exporters because even if the devaluation induces no additional exports, the revenue of the exporters, in terms of the domestic currency, will increase by the full 13/ There are, of course, the "traditional" games of overinvoicing and underinvoicing, played by exporters and importers. But these are separate problems that can be tackled with other means, being essentially another manifestation of the "transfer-pricing" problem. Lawrence Lau on Guo Shuqing 25 extent of the devaluation, and hence their profit will increase more than proportionately. 4/ The exporters can, therefore, well afford to pay an export tax as long as the tax rate is less than the extent of the devaluation. The current official exchange rate is approximately 5.84 Yuan per US Dollar. The rate at the adjustment centers in the major cities is now between 8 and 9 Yuan per US Dollar. With a one-time devaluation of, say, between 1 and 2 Yuan per US Dollar, the exporters will realize an increase in revenue in terms of the domestic currency, even with no increase in demand, of approximately 10-20 percent, and a considerably larger percentage increase in profit. They can thus absorb the impact of, say, an export tax of 10 percent on the value of the exports. In fact, the exporters will be better off with the combined devaluation and imposition of an export tax than without. And if the devaluation stimulates demand for additional Chinese exports, they will do even better. It is not necessary to tax imports directly because the importers already have to bear the burden indirectly through the increase in the cost of imports, in terms of the domestic currency, as a result of the devaluation. In practice, the only importers who are likely to be penalized are those with preferential access to foreign exchange at official rates. For those importers who have to obtain their foreign exchange through the adjustment centers, the cost of imports will not be much affected, provided that the practice of de facto multiple foreign exchange rates is discontinued. If necessary, part of the revenue raised from the export tax can be used as a direct subsidy for certain imports, for example, grains, for a transitional period. One useful way of thinking about the proposed taxation scheme is that the devaluation has the effect of transferring profit from the importers to the exporters. Thus, with a concurrent devaluation, a tax needs to be imposed only on exports. Ten percent of the value of all Chinese exports can easily amount to more than $10 billion in a couple of years, or approximately 2 percent of Chinese GNP, which is quite significant, especially since exports are expected to continue to grow much faster than GNP in the foreseeable future. Moreover, this source of revenue will be protected against inflation; as inflation increases, the price of exports in terms of the domestic currency will rise, and hence revenue from an export tax will increase proportionally. Finally, foreign countries are not likely to complain about the imposition of a proportional export tax, as they might about an import tax, because the former results in a higher effective price for Chinese exports in the world market than otherwise, other things being equal. There is also a question of the proper timing for the implementation of this proposed scheme. Like all devaluations, once it has been decided, it should be carried out as quickly as possible so as not to give speculators a chance to profit. Moreover, the proposed scheme, because of its effects on the budget surplus (positive), exports (partially negative), investment (negative), is likely to be, on balance, noninflationary, despite the fact that the price of imports in terms of the domestic currency will rise. 14/ This is because only the import component of the cost of production will rise with a devaluation. The domestic component of the cost of production is unaffected. 26 Comment A second feasible taxation scheme is an energy tax. Assuming that the price to the energy users is adjusted to either the free-market level or, what amounts to approximately the same thing, the world-market level, a uniform energy tax, based on the realizable heat content of the energy resource, can be levied on the producers. Under this scheme, the price to the energy users is unchanged, but the energy producers will have to pay a tax to the Central Government, and in effect, share the increase in the price of energy from its current level to the market level with the Central Government. However, even with the tax, the energy producers are still better off than before. One way to construe this tax is that it is the royalty for the extraction and use of the energy resource in the ground, which is owned by all the people. This energy tax can be a major and increasing source of revenue, especially since energy demand is likely to rise much faster than real GDP for a country in China's stage of economic development. Another form of energy tax that can potentially become a major source of revenue is a gasoline tax. A gasoline tax of, say, $2 per gallon (approximately the level of the Western European countries and Japan) can generate a great deal of revenue after the turn of the millennium, as the number of Chinese motor vehicles increases with economic growth. It will also have a long-term benefit by encouraging the development of mass transit and hence reducing environmental pollution. Politically, it is much easier to impose a gasoline tax now, when only a privileged few own private motor vehicles, than when there are a large number of motorists, as in the United States, who will oppose any increase in the gasoline tax. A gasoline tax will also win credit for China in international circles as an environmentally concerned country. Both energy taxes proposed also satisfy the requirements that they raise significant new revenue for the Central Government; grow with GNP and inflation; are relatively easy to administer; 15/ and are broadly perceived to be "fair." Finally, the concept of a "consumption" tax has gained much currency and support among the professional economic circles in the West. It is based on the idea that private consumption rather than income should be taxed to individuals and households and, by extension, to enterprises. An individual or household may have a very high income, but as long as the income is reinvested, that is, not consumed personally, the tax on that portion of the income that is saved or reinvested will be deferred, or postponed. However, if the individual or household spends the income on personal consumption, e.g., purchases an air conditioner for the house, a tax will be paid on that portion of the income that is consumed. A consumption tax thus encourages saving and investment and discourages consumption. It is thus by definition not neutral. A consumption tax does not mean that taxation is escaped forever; if at some future date the individual or household decides to increase personal consumption, additional taxes will have to be paid on the additional consumption even if there is no current income. The government, if it wishes, can also recapture some of the lost revenue through estate taxation. 151 For example, the energy and the gasoline taxes can be collected directly from the producers and refiners. Lawrence Lau on Guo Shuqing 27 Since a consumption tax essentially exempts income that is saved or reinvested from current taxation, it puts additional resources in the hands of those who have both the ability to produce income and the inclination to invest. Thus, not only are aggregate savings (and investments) likely to increase, but they will be more likely to be under the control of people who have a track record of successful investments and can make best use of the savings, thus enhancing the overall efficiency of investment for the society as a whole. The Chinese have a saying, referring to the behavior of provincial and local governments, of "storing wealth in enterprises." A consumption tax implies a strategy of "storing wealth in capital," leaving resources in the hands of those who can use them most efficiently. Another implication of a consumption tax is that the investors will be using "their own money" rather than government subsidies or bank loans for the investments and can therefore be expected to be more prudent and selective. 16/ With a consumption tax, the government can actually exploit the private motive for accumulation for the public purpose of maximizing both the rate and the efficiency of capital accumulation in the economy. However, what is novel about my proposed consumption tax scheme is its method of implementation. Implementation of a consumption tax at either the individual or household level is even more complicated than the implementation of an income tax, and that is not what is recommended here. Instead, my proposed taxation scheme is based on the taxation of the consumption of luxury goods with high income elasticities of demand, such as air conditioners, automobiles, cameras, motorcycles, refrigerators, television sets, VCRs, and washing machines. 17/ The tax is to be directly imposed on and collected from manufacturers of the commodities, or, alternatively, the manufacturers of key components of these commodities, rather than individuals or households. For example, an ad-valorum tax may be levied on air conditioners and refrigerators ex-factory, that is, as they are shipped from the manufacturing plants. The tax will be paid directly by the manufacturers, who will in turn add it directly on their sale price to the wholesale and then the retail distributors, and ultimately will be borne by the actual final consumers. The households that have the ability to purchase air conditioners and refrigerators tend to be relatively well-to-do households and they will in actual fact bear the burden of the tax. Households too poor to afford air conditioners and refrigerators will pay no tax at all. Thus such a tax is also "progressive" in the sense that higher-income individuals and households are likely to pay a higher proportion of their income as taxes. Moreover, even individuals and households with illicitly generated income will bear the burden of this tax to the extent of their consumption. Now there are far fewer refrigerator factories in China than individuals or households and a tax of this type can be collected entirely at the factory level at very low cost. 18/ An alternative is to focus the taxation on critical components of certain luxury 16/ In other words, there should be no or less of an "incentive incompatibility" problem. 17/ One may also wish to include private residential housing and expensive restaurant meals. 18/ For example, one or more tax inspectors can be sent to each of the factories on a rotating basis. 28 Comment consumption goods, for example, on compressors (for air conditioners and refrigerators), lenses (for cameras), or color television picture tubes (for television sets), the number of Chinese producers of which must be even fewer. 19/ The same tax should apply to both domestically produced and imported goods (or components). The revenue from such a taxation scheme will increase with inflation, because of its ad-valorum nature, and with GNP per capita, because of its basis in consumer demand. Moreover, given the high income elasticities of the demands for these consumer durables (typically greater than unity), the total tax collected from this source is likely to rise much faster than GNP as the economy grows. E. SPECIFIC MEASURES FOR REFORMING THE SYSTEM OF MACROECONOMIC MANAGEMENT Professor Guo has made some very sensible specific suggestions for reforming the system of macroeconomic management in China. Let me comment on a few of them: (a) The unification of macroeconomic management. While everyone will agree that coordination is important between the fiscal and monetary authorities, so that their respective actions are not at cross purposes, the superiority of vesting all authority for macroeconomic management in a single government agency is not clearly established by the available empirical experience. In fact, there is a tradition in some countries, for example, the United States, of an independent central bank that controls and regulates money supply, credit, the rate of interest and the exchange rate, but this tradition is far from universal. However, experience has shown that countries with independent central banks tend to have lower rates of inflation. In the long run, a more politically independent central bank is probably more beneficial to China. (b) The transparency of government finance. Professor Guo has suggested that government deficits should be financed through the issuance of public debt securities (including bills, notes and bonds) rather than overdraft facilities at state-owned banks. This practice has the virtue of making any budget deficit explicit, especially if the "off-budget" revenues and expenditures are also consolidated. By making the true financial situation of the country more clearly identifiable to both the government and the general public, it will be easier to avoid incurring excessive budget deficits. And to the extent that the budget deficit is under control, the task of stabilization of the economy is also made easier. However, in order to properly assess the budgetary situation, the government should, in addition to consolidating all of the "off-budget" items, maintain separate current (operating) accounts and capital accounts. One is not as concerned by a 19/ As a practical matter, such taxes should be centrally collected by the Central Government and not delegated to the provincial and local governments, so that the taxes can be uniformly enforced. Lawrence Lau on Guo Shuqing 29 one-time deficit in the capital account but one should be worried by a large recurrent deficit in the current (operating) account. (c) Restrictions on government investments. Professor Guo has also suggested that the practice of direct funding from the government budget of investments in enterprises should be stopped. I have also made a similar proposal elsewhere.20/ I would go further than Professor Guo to say that even indirect funding, through loans from state-owned banks, should also be forbidden. Moreover, state-owned enterprises should not be allowed to borrow except for short-term working capital purposes and only under conditions that would prevent the funds from being diverted for unauthorized fixed investments.21/ Thus, only state-owned enterprises that generate profits themselves will be able to make new fixed investments. The only exceptions are for investments in infrastructure and in pioneer industries that otherwise would not have been undertaken. The government should invest in or provide investment funds for only infrastructure and pioneer industries, on the grounds of the positive externalities that these investments may generate. In these cases, any bank financing necessary should be through loans made by a development bank and not by a commercial bank-there should be a suitable division of labor between the two types of financial institutions. In general, the government should not try to compete with enterprises unless there is a good reason to do so, e.g., clear evidence of a profit-gouging monopoly. (d) Control of bank credit. For state-owned commercial banks, bank credits should be limited to those for working capital needs only, with full protection against diversion for fixed-investment purposes.22/ Nonstate- owned banks should be discouraged, if not disallowed, from lending to state-owned enterprises at all. Nonstate-owned banks should also be supervised and regulated to protect the integrity of the banking system. However, this is difficult in practice, even for the United States. Perhaps the only effective measure is to require the nonstate-owned banks to maintain a high capital to asset ratio, for example, 20 percent, so as to 2Q/ See L. J. Lau, "Macroeconomic Policies for Short-Term Stabilization and Long-Term Growth of the Chinese Economy," Working Paper No. 101, Asia/Pacific Research Center, Stanford University, December 1992. 21/ This is because the banks, whether state-owned or private, ultimately look to the government for repayment of any debt incurred by the state-owned enterprises. 22/ This implies the adoption of the "real bills" doctrine of commercial banking. 30 Comment minimize the incentive on the part of nonstate-owned banks to take undue risks.23/ (e) Unification of the price of foreign exchange. Professor Guo has also suggested the unification of all the different effective exchange rates into a single rate. I heartily endorse this proposal. However, while I believe there will be significant efficiency gains if the prices of foreign exchange for current transactions (e.g., trade in goods and services) are unified and the restrictions on trade are simplified and reduced, I am not so sure about the magnitude, if any, or indeed of the direction, of the net benefit, of an across-the-board removal of restrictions on outward capital flows. There is a possibility of a vast capital flight if the restrictions are removed today.24/ Both Japan and Taiwan (China) removed their restrictions on outward capital flows only gradually and long after their currencies had become stable and strong in the foreign exchange markets. What looks like a substantial Chinese reserve can quickly disappear after a few years of healthy growth and high investment. For example, this year, China will probably have a deficit in its current account. There is no debate on the desirability of a single price of foreign exchange for the purposes of international trade. However, full and unrestricted convertibility on the capital account has potentially large but not fully predictable consequences and should only be viewed as a distant goal.25/ (f) Unification of internal markets. For many reasons, it is in the interest of the Central Government to ensure a unified internal market. These reasons include considerations of competitive efficiency (a single price for the same commodity everywhere), regional equity, and exploitation of economies of scale and other dynamic externalities. To this end, the removal of tangible and intangible internal barriers to trade and capital flow and the undertaking of infrastructure investment linking the whole country should be priority policy measures of the Central Government. From the perspective of macroeconomic management, the unification of internal markets minimizes the possibility of the economy being overheated in one region and in deep recession in another region as well as limits the disparity of living standards across regions, and thereby facilitates the tasks of achieving stabilization and balanced growth. 23/ Such a rate is, however, 150 percent higher than the 8 percent required by the Bank of International Settlement rules. 24/ Of course, this depends partly on the level of the exchange rate. L/ There is, of course, no reason not to allow convertibility, at market prices, by foreign investors in China for the purpose of repatriation of their capital and profits, provided that all necessary taxes have been paid. Lawrence Lau on Guo Shuqing 31 F. CONCLUDING REMARKS There are a number of other important issues that deserve attention. They are: (a) Effective macroeconomic management depends not only on a knowledge of the structure of the economy but also critically on timing and in particularly on timeliness. The relationship between targets and instruments are characterized by long and variable lags. Measures that are supposedly helpful may turn out to be actually harmful if enacted too late. A system of leading, coincident and lagging indicators applicable to the Chinese economy should be developed to assist in the determination of the optimal timing of macroeconomic policy measures. (b) Another important function of macroeconomic management is coordination of investment decisions so as to maximize complementarities and externalities and avoid wasteful duplication. Coordination does not necessarily imply central planning; it can be achieved through continuous and timely dissemination of relevant information on new and potential investment projects. The market can be relied on to lead to the best allocation of new investments only if all participants and potential participants have the correct information.2/ Institutions and mechanisms should be devised so as to facilitate the timely dissemination of nonproprietary, nonmarket information. (c) The valuation as well as the determination of the ownership of and rights and obligations related to assets under the control of existing state-owned enterprises is a task of the highest priority. If nothing is done, in a few more years, these assets will be treated, de facto, as if they are owned by the existing managers and workers of the respective enterprises. If this happens, it will amount to a huge give-away on the part of the Central Government, since these assets can conceivably be used to raise revenue with which to reduce the structural budget deficit on a permanent basis.27/ (d) Finally, whether certain macroeconomic management techniques work depends on the new behavioral norms and rules of enterprises (including 26/ The coordination function can also be achieved through some form of signaling. For example, the publication of the news of the visit by Mr. Deng Xiaoping to southern China in 1992 can be regarded as such a signal. The ensuing publicity stimulated one of the greatest investment boom in the Chinese economy. A forecast by the Central Government, if widely credible, can also have the same signaling effect. 27/ While proceeds from the sales, or single-payment long-term leases, of assets can also be used to reduce the current (operating) budget deficit, unless the structural budget deficit is permanently reduced, there will eventually be a day of reckoning when the stock of salable or leasable assets runs out. 32 Comment private and township enterprises) and households. This reemphasizes the importance as well as urgency of "restructuring the economic system." I am often asked whether China will develop in the same way as the four "Little Dragons"-Hong Kong, Singapore, the Republic of Korea and Taiwan (China). My answer is always no. There is no way that China can ever achieve the same level of exports, on a per capita basis, as these four economies. There are simply not enough customers. This does not mean, however, that the "open-door" policy is wrong or useless. It is useful in bringing in not only technology and capital but most important of all a new outlook, attitude and behavior-a new way of doing things in organization, production, marketing and service, as well as new challenges and competition, leading to renewal and continual improvement. China does have two major advantages over these four economies: a relative abundance of natural resources and an enormous domestic market. With the potentially huge domestic market, China can readily take advantage of scale economies, without having to rely on the export market. For example, Taiwan (China) has struggled for years to establish an automobile industry. However, a minimum efficient-scale plant has to produce 200,000 motor vehicles per year. Without an export market, such a scale cannot be achieved in Taiwan. For China, the domestic demand of motor vehicles per year will probably exceed 200,000 units before the end of the century. In fact, future Chinese economic development is likely to be more similar to that of the United States in the late nineteenth and early twentieth centuries. There, imported capital and technology initially played a leading role. Subsequently, as the domestic market developed, the dynamic interactions of internal demands were able to sustain continual economic growth. The foreign sector, while pivotal in getting American economic development started, was never a dominant part of the US economy, as it is for Japan and Taiwan (China). The US experience suggests that for a large economy such as China's, once the process of economic development gets started and gathers enough momentum, it can become internally self-sustaining. A "bootstrap" strategy that does not work for much smaller economies may work in China. The extent of the Chinese market allows the specialization and division of labor that generate added economic value without regard to the export market. As a result, Chinese economic development will eventually be much less dependent on the cyclical fortunes of other economies. The boom of 1992 shows that it is possible for concerted actions prompted by a common expectation to get the economy moving forward again. If every one believes that the economy will be growing rapidly and acts accordingly, the economy will in fact grow rapidly, provided that the initial productive capacity is in place. Mr. Deng Xiaoping's southern visit provided precisely the signal for the convergence of public expectations. In order to maximize the benefits of China's unique advantage of its huge domestic market, the Central Government must pursue the development of infrastructural links and at the same time resolutely outlaw tangible and intangible internal trade barriers within China. By concentrating on infrastructural investments and restraining inefficient enterprises from wasting new sources, China will be able to increase the efficiency of its Lawrence Lau on Guo Shuqing 33 new investment. By taking care that inflation and the budget deficit do not get out of control, China will be able to moderate its boom and bust cycles and stay on a smooth but rapid growth path. Then with its huge domestic market, it may potentially become the next engine of growth not only for Asia but also for the rest of the world. Wu Xiaoling and Xie Ping 35 MONETARY POLICIES IN CHINA'S ECONOMY IN TRANSITION Wu Xiaoling and Xie Ping 1/ A. INTRODUCTION The objective of China's monetary policy is to focus on stability of the currency in the process of changing to a market-oriented economy, rather than on growth of the economy and price stability. In the past few years, China's monetary policy has also been used to adjust the economic structure, which was achieved mainly through the input of base money without any recalling of it. This process has hindered adjustment of aggregate money supply and currency stability. Clear distinction needs to be made between the functions of monetary policy and fiscal policy in China, and a separate institution specializing in policy-oriented financing needs to be established. At the same time, from an institutional point of view, a clear separation should be made between policy-based financing and commercial financing; open-market operations should be one of the monetary policy tools. In this paper, the authors also express their ideas about financial reform in China. B. ORJECTIVE OF THE MONETARY POUCY China's monetary policy has experienced a difficult period in the pursuit of growth of the economy and currency stability and, sometimes, adjustment of the economic structure. This is the outcome of a planned economy that allocated bank credit directly. This is quite different from the resource allocation mechanism of a market economy that is based on market forces (the "law of value"). With the transition of China to a socialist market economy, the direct role of government in resource allocation has declined and market forces will play a more important role in determining prices. Under the regime of a market economy, control of aggregate demand and price will, to a large extent, rely on control of the money supply. Thus, the monetary policy of the central bank will focus on the objective of currency stability to promote steady development of the economy. Credit Control With the economic reform of the past 14 years, the degree of reliance of China's economy on the financial sector has increased gradually and the impact of changes in aggregate money supply on the economy has also increased. The rapid increases of M1 in 1984, 1988 and 1992 contributed significantly to the fast growth of the economy. In contrast, the negative increases of the economy in the first quarters of 1986 and 1989 were 1/ Ms. Wu Xiaoling is deputy director of the Department of Financial System Reform, People's Bank of China (PBC), and an associate research fellow. Mr. Xie Ping is division chief of the Research Department and an associate research fellow. The views expressed in this paper are those of the authors and do not necessarily reflect those of the People's Bank of China. 36 Monetary Policies in China's Economy in Transition primarily the result of an insufficient money supply in 1985 and 1988; the growth rate for the whole year was also low. With a highly monopolistic banking system and an overreliance of enterprises on bank credit and of credit control on administrative measures, it is very difficult to control the degree of money supply expansion, and inevitably, the economy will become unstable. The reliance on administrative measures to control credit has made it difficult not only to control the total amount but also the structure of credit; it has also promoted fluctuation of the money supply. The financial sector in China is a highly monopolistic business. At the end of 1992, 92 percent of the financing received by the nonfinancial sector came from loans extended by financial institutions, among which 71 percent came from loans extended by the four specialized banks. The four specialized banks act as commercial banks as well as policy-lending banks. There is neither a self- constraint mechanism nor free competition, and the central bank has been forced to increase the money supply. With an overexpanded base money, credit ceilings are the only way available for the central bank to control credit. However, under heavy pressure from the specialized banks and even from PBC branches, the credit ceiling has often been adjusted. Since 1989, credit ceiling adjustments have been more than 30 percent over target and the difference between the increase in credit and in the money supply has grown and its impact on the instability of the economy has been significant. The increase in affordable aggregate demand is basically determined by the increase in broad money, which equals M2 in China. Loans do not become direct purchasing power until borrowers (enterprises, individuals) deposit them in banks or cash them, at which time payment can be made directly and only in this case do loans become direct purchasing power. With regard to the impact of credit control on aggregate demand, some basic conclusions can be reached from a comparison between the increase in loans and M2. Table 1 shows the increase in M2 and loans (extended by state-owned banks and rural credit cooperatives) in the past 10 years in China. Table 1: COMPARISON BETWEEN THE INCREASE OF M2 AND LOANS, 1983-92 (Y 100 million) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 M2 (1) 520 1,250 756 1,522 1,665 1,711 1,856 3,312 4,088 6,050 Loans (2) 646 1,352 1,183 1,845 1,650 1,679 2,011 3,085 3,269 4,228 (1)-(2) -126 -102 -427 -323 15 32 -155 227 819 1,822 From Table I we can see that before 1990, the increase in loans was larger than in M2, indicating that, in this period, adjustment of the scale of loans had some effect on adjustment of aggregate social demand. After 1990, the difference between the increase in M2 and in loans increased dramatically and in 1992, it accounted for 43.1 percent of the latter. In this case, the credit ceiling had little effect on adjustment of aggregate Wu Xiaoling and Xie Ping 37 demand. Thus, the development of a market economy has a profound impact upon the instruments used in a planned economy. The reasons underlying this are the development of a financial market, the diversification of the financial instruments and the endorsement of operational autonomy of specialized banks and other financial institutions. The overreliance of enterprises on bank credit has left no cushion for the implementation of a monetary policy and affects the instability of the economy directly. The ratio of an enterprise's own capital decreased gradually, especially for state-owned enterprises. Before economic reform, the funds used for fixed-asset investment came mainly from government appropriation, and the enterprise's own funds accounted for 52 percent of working capital, but in 1992, 40 percent of fixed-asset investment and 80 percent of working capital came from loans by banks. Although the capital market in China has developed in the past few years, financing through it has only accounted for 8 percent of total financing. Most of the external financing of enterprises came from loans by banks. When the money supply is tightened, enterprises have no other alternatives to acquire funds, and can be affected directly and strongly. Under this regime, it seems that the monetary policy affects economic growth directly, but in fact, it cannot control the aggregate amount of money effectively and because there is no cushion for the implementation of a monetary policy, it inevitably increases the instability of the economy. Efficient Resource Allocation In a market economy, an increase or decrease in the money supply does not affect resource allocation directly. Resource allocation is the result of market forces and the average rate of return, rather than the result of changes in money supply. Money supply will affect the interest rate, which in turn will affect enterprises' demand for credit. But, at any given interest rate, the allocation of funds is determined by the prices of commodities. Growth of the economy not only means an increase in the total amount, but also, and much more importantly, means an improvement in the efficient use of resources. An improvement in the use of resources requires a stable measurement of various kinds of resources and a price system that should facilitate a comparison of inputs and outputs, i.e., stability of the currency. Under a system where the government takes responsibility for the promotion of economic growth and is engaged in the management of the economy directly, the focus of a monetary policy is usually on the growth of the economy and the significance of monetary stability is neglected. Nearly all governments share the same responsibility for promotion of economic growth, but in the process of achieving this objective, governments in market economies usually devote themselves to the creation of an environment with equal competition and an organized economic order. Thus, they have paid considerable attention to improvement of the legal environment and the economic system. Normally the government is not the entity that should take primary responsibility for economic activities and their outcome, so there is no pressure for the government to intervene in the financial sector directly. But for a economy in transition like China where the market and competition are in the formative stage, the government is the one who shall take primary responsibility for the outcome of economic activities. In this case, it is natural for the 38 Monetary Policies in China's Economy in Transition government to intervene in the financial sector directly. For example, efficient use of resources is a very critical issue for China, which has a large population and relatively poor resources. In order to improve efficiency, it is necessary for some of the low- efficiency enterprises to be closed, but the ensuing unemployment has made it very difficult for the government to implement the Bankruptcy Law and expansion of credit is the only way for the government to release the tension: continually financing high-efficiency enterprises to sustain economic growth while continually financing low-efficiency enterprises to ensure social stability. Obviously, it is very difficult to optimize resource allocation, and inflation pressure also increases. Currency Stability With the high growth rate of the economy and the speeding up of the development of a market economy, it is necessary to concentrate on stability of the currency since an organized financial system is conducive to long-term stability and sustained growth of the economy. Factors underlying growth of the economy determine the demand for money. Funds are very important for growth of the economy, but a much more important factor is the rational allocation of resources. A financial system with high efficiency can promote the optimal allocation of resources through the flow of funds. Thus, the establishment of such a system and the sustained viability of it should be a major task of the central bank. The effectiveness of monetary policy in China is based on the efficient and orderly operation of the financial system. Therefore, it is necessary for the central bank to strengthen supervision of financial institutions. Using credit expansion to ease conflicts occurring in the process of economic transition is just postponing resolution of the problem and is very dangerous. It is hoped that high-efficiency enterprises can offset the inflation pressures created by low-efficiency enterprises, but, in fact, it is quite possible that inflation pressures may increase more quickly than any offsetting mechanisms and another round of inflation may seriously impede economic development. Thus, the much more effective way is to speed up reform in other areas while maintaining currency stability. C. CURRENCY STABILITY AND ADJUSTMENT OF THE ECONOMIC STRUCTURE An unreasonable economic structure is a large barrier in the process of economic development in developing countries. How to adjust the economic structure is a problem that needs to be resolved in order to reform and develop China's economy. Two Channels for Restructuring the Economic System In a market economy, adjustment of the economic structure has usually been carried out by the market mechanism, i.e., through the automatic function of market forces and the law of average rate of return. When the allocation of resources is not reasonable, the price of scarce commodities and scarce resources will increase and produce excess profits for these items. Credit and funds will flow to sectors producing scarce commodities and resources, to further develop these sectors. Wu Xiaoling and Xie Ping 39 This can be a very slow process, with many enterprises declaring bankruptcy, which can even lead to another round of economic recession. With this bitter experience, governments began to intensify intervention in the economy. Many countries have paid a lot of attention to the program of economic development in the period of reconstruction after World War II. Countries like Japan and Korea have enhanced the guidance of the government through industrial policies to overcome "blindness" in economic development. In highly centralized economies, development of the economy and its structure is usually formed under the state economic development plan. Adjustment of the economic structure is usually carried out by direct planned allocation of resources. The largest advantage of this system is its capacity to concentrate national resources for the construction of large projects and to achieve rapid adjustment of the economic structure. For example, during the first eight years after the establishment of the People's Republic of China, the war-damaged economy was restored and, with the establishment of the 156 key projects financed by the USSR, a framework for the industrialization of the national economy was created. China also made a very important breakthrough in space technology in a short period of time, and at a lower level of economic development than other countries. The disadvantage of a planned economy is that it is usually constrained by the cognitive ability of the human being; a small human mistake will usually lead to a large economic loss. The experience of socialist countries in past decades demonstrates that a mandatary plan cannot achieve the optimal allocation of resources, and reform is an inevitable trend for these countries. The experience of China in its economic development demonstrates that neither "only market, no plan" nor "only plan, no market" could sustain steady development of the economy. The government is now trying to find the best way to combine these two parts. Monetary Policy and Fiscal Policy Monetary policy and fiscal policy are two major instruments of market- economy governments to fulfill the function of adjustment of the macroeconomy. A reasonable explanation of the function is that it is the responsibility of monetary policy to reach equilibrium between aggregate demand and supply, to maintain stability of the currency and to create a stable price system for operation of the economy. Fiscal policy can guarantee equity in society and intervene in key reforms of the economic structure. Market forces are the basis for resource allocation in a market economy. With high inflation, the price of a commodity cannot give a correct signal of the scarcity of resources and the investors cannot reach a reasonable judgment about rates of return. In this case, there is little to say for the optimal allocation of resources. Adjustment of the economic structure by monetary policy usually will lead to excessive input of money and inevitably will induce inflation and affect economic stability unfavorably. The most difficult problem with respect to financial control in China is that the central bank has undertaken directly policy-based lending. The base money of the central bank, through relending by specialized banks, flowed to some of the important 40 Monetary Policies in China's Economy in Transition economic sectors or projects that needed funds urgently. This formed a mechanism that base money only flows out of but does not flow into the central bank, making it very difficult to adjust money supply through adjustment of base money. From Table 2, we can see that in the balance sheet of the People's Bank of China (PBC), direct financing of financial institutions (mainly state-owned specialized banks) accounted for a large proportion of assets. Table 2: PBC STRUCTURE OF ASSETS /a (Percent) Loans to Overdrafts of Gold and financial the Ministry foreign Direct institutions of Finance exchange loans 1985 77.9 13.6 2.0 2.5 1986 78.2 14.0 1.2 3.5 1987 73.2 16.6 1.1 4.4 1988 74.9 15.3 1.7 6.7 1989 72.9 13.7 4.5 5.6 1990 70.6 12.5 8.2 5.4 1991 66.6 13.1 13.6 4.9 1992 67.8 12.2 11.0 5.6 /a The residual are the assets in international financial organizations. Source: Annual Report of the People's Bank of China, 1992. As monetary policy is currently responsible for economic restructuring, it is necessary to employ administrative means to control credit ceilings. In a market economy, the amount of credit commercial banks can extend depends on the amount of deposits they obtain. Usually, the more deposits they receive, the more loans they can make. In China, however, the majority of depositors are attracted to better-developed areas in the coastal provinces, while western and central inland areas lack deposits and consequently are in dire need of credit. If the principle of "more deposits, more loans" was followed, more funds would be directed to coastal areas, thus aggravating the disparity in the level of development across different regions. To avoid such a situation, PBC has been delegated to correct imbalances in levels of economic development among different areas. The 13 percent required reserves submitted by financial institutions are not for the purpose of keeping reserves with the central bank; rather they are used for closing financing gaps across regions. It is ordinary deposits by financial institutions with the central bank that are used to meet reserve requirement needs. In light of the financing gaps between coastal and inland areas, 13 percent is not enough. In this context, PBC Wu Xiaoling and Xie Ping 41 gaps between coastal and inland areas, 13 percent is not enough. In this context, PBC restricts credit extension by imposing credit ceilings. Strong demand by coastal provinces for more autonomy in making decisions regarding the amount of credit they can extend reflects the fact that those areas cannot make loans based on the amount of deposits they obtain. That PBC has not abolished credit ceilings to allow coastal areas to make more loans also reveals that the inland provinces are reluctant to make fewer loans solely because they receive fewer deposits. The task of correcting the economic structure among regions puts PBC in an awkward situation. Being entrusted to correct the economic structure, PBC faces difficulties, on the one hand, in controlling base money and, on the other, in achieving the principle of "more deposits, more loans." In any event, PBC has to rely on administrative means to control credit aggregates. This undermines one of the most important factors of production to be allocated by market forces-capital-thus resulting in poor resource allocation. The budget is a reflection of national interests. To secure national development and social stability, budgetary authorities need to manage money for the state, in order to ensure social equality. Investments that are good for long-term social interests and for the general public may not earn an average rate of return. In this respect, financing has to be sought from the budgetary authorities, which represent the government. Large amounts of investment financed by the government can change the economic structure in the short run. With the improvement of market mechanisms and with the economy getting onto the right track, the share of government investments can be gradually reduced. After World War II, the Japanese government successfully fostered a high rate of economic growth and changes in the economic structure through a large amount of investment. The sources of government investment may come from taxes and government credits. Open-Market Operations With the advent of reform and opening up, the economic structure has undergone dramatic changes compared to the prereform period. To the extent possible, earlier problems of overinvestment in heavy industry, underinvestment in light industry and the dominant role of farming in the agricultural sector have been addressed. However, the pricing system under the centrally planned economy has not been changed completely, giving rise to less profitability in basic industries than in manufacturing industries. Therefore, with decentralization of decision-making on investment, the development of basic industry lags behind the manufacturing sector. This results in bottlenecks restraining economic development. To address the bottlenecks, it is necessary both to speed up price reform and to increase investment by central government. Since the reform, the share of the central budget in national income has gradually declined. With the rapid pace of development of the economy, more investment is needed in infrastructure and basic industry. In any event, more investment should be made by the central government. The financing burden on the central budget becomes heavier, giving rise to increased fiscal deficits. The fiscal deficit is currently financed by bond issues and overdrafts from PBC. In addition, the banking system has been forced to extend money that should be provided 42 Monetary Policies in China's Economy in Transition by the budget. This is not good for correcting the economic structure, nor for distinguishing responsibilities between banking and fiscal institutions. Therefore, PBC loses autonomy in determining the appropriate level of money supply. In making macroeconomic management effective, there is a pressing need to make a clear distinction between budgetary and bank financing. China is evolving toward monetization of the economy and financial deepening. Each year the money supply grows by a large margin; so does base money. Because of a lack of necessary policy instruments in the past, base money was generally provided in the form of credit to the specialized banks. When PBC provided base money, it was usually to finance policy lending. It is necessary to set up institutions that would take over these policy-lending activities from specialized banks, in order to change the latter into genuine commercial banks. The policy-oriented banks would issue bonds guaranteed by the government to the public and financial bonds to financial institutions, with the purpose of securing the financing needed for key construction projects. PBC can create credit through open-market operations, and buying and selling of treasury bills or bonds with government guarantees and financial bonds issued by policy-oriented banks, or by using these securities as collateral. All depository banks will be allowed to buy financial bonds. PBC, however, would only provide short-term financing to national commercial banks. In creating base money through open-market operations, PBC can have more autonomy. D. EVOLUTION OF INDIRECT MACROECONOMIC MANAGEMENT AND THE FINANCIAL SECTOR With the establishment of a policy-oriented banking sector and PBC creating base money through open-market operations, macroeconomic management in China will be based more on market forces. To achieve these objectives, a series of measures are needed. Establishment of a Government Financing Framework To accomplish economic restructuring, China can learn from Japan's experience of establishing its own government financing framework. There are two kinds of resource allocation within a government financing framework. One is related to accumulation of state assets, which can be done by establishing a few intermediaries to manage on behalf of the government. Another is financing by policy-oriented financial institutions. Its funds can come from (a) capital expenditure from the budget; (b) postal savings and social security surplus; and (c) issuance of national debt and other government- guaranteed bonds. Intermediaries managing state assets might include investment companies or holding companies. Discussions on the operational modalities of these institutions can be found in other papers. Establishment and operational modalities of policy-oriented financial institutions should be along the following principles: Wu Xiaoling and Xie Ping 43 (a) Coverage of policy-oriented financial activities must be drastically reduced. Policy-oriented financial activities cover a broad spectrum. Many loans provided by financial institutions in accordance with government industrial policy and on behalf of PBC have also been defined as policy- oriented loans. Policy-oriented loans are strictly defined as those longer- term investments that cannot afford market interest rates and are of critical benefit to society. As a result of trade reform and agricultural marketing and price reform, policy-oriented lending in the future will include (i) capital goods exports; (ii) infrastructure and basic industries (including agriculture); and (iii) storage of key materials-including agricultural crops. (b) Principle and interest must be repaid. Policy lending should not follow the principle of profit maximization. It is not budgetary financing. Projects financed by policy lending must have the potential for repayment. If not, they should be financed by the budget. Although policy lending rates can be lower than market rates, they should be at the same level as basic rates of the central bank. In this way, policy-oriented financial institutions can make ends meet. The current level of interest rates is too high for many basic industries and infrastructure. During the transitional period, this can be addressed by budget subsidies. The underlying solution is to reform the pricing system. (c) Policy-oriented financial institutions should be independent decisionmakers and take risks under the guidance of the national industrial policy. The primary problem in a planned economy is that nobody takes ultimate responsibility for projects. Policy-oriented financial institutions are a mechanism to make clear the responsibility regarding projects by directing financial resources through financial intermediaries. (d) Policy-oriented financial institutions should be efficient. They should focus on determining appropriate investments. As for operational activities, they can be done through auctioning and bidding practices or delegated to other financial institutions. Under the current circumstances in China, policy-oriented institutions can be established to support capital construction and agriculture. National Commercial Banks, Capital Markets, Risk-Taking Mechanisms and Market Mechanisms The objective of reform should be to channel funds to profit-making sectors through banks and capital markets, in order to accomplish optimal allocation of resources. It will also facilitate use of the market mechanism to foster economic development. To establish such a mechanism, first and foremost, specialized banks have to be allowed to separate policy lending from commercial activities, with the purpose of making them operate in line with principles of profit maximization and soundness and liquidity, and having them become responsive to market signals. In addition, a self-regulated capital 44 Monetary Policies in China's Economy in Transition market has to be set up. The primary problem prevailing in the capital market is that risks associated with investment, which should borne by investors, have been shifted to the state through various means. Therefore, the capital market has a tendency toward unchecked expansion. Third, a flexible credit control framework has to be instituted. Given the demand for money, when the share of investment through capital markets increases, bank credits should be reduced accordingly, in order to secure a favorable environment for correcting the economic structure. Under conditions of excessive credit expansion, irrational development, which was often seen in the old system, will inevitably reemerge. Improved PBC Macroeconomic Management When the task of economic restructuring has been shifted to the budget and financial markets, the central bank should focus on managing the money supply, in order to secure a balance between aggregate supply and demand, and to create a stable monetary environment for economic development. To implement financial management effectively at the macro level, in addition to continuing concerted reform efforts in the areas of enterprises, prices, the tax system and investment mechanisms, central banking reform should be a primary task of financial sector reform. Stepped-up efforts must be made to establish and improve the statistical and information system of PBC, with the aim of ensuring timely and accurate statistical data on macroeconomic development and operations of financial institutions. At the very least, PBC should have available daily information on excess reserves of financial institutions and changes in money supply every 10 days, in order to support macroeconomic management. The current practice of establishing branches and other outlets of PBC according to administrative divisions should gradually be changed into one based on economic needs. Gradually, departmental arrangements within PBC should be made based on its different functions, rather than on different operations as is currently done. Internal conflicts should be reduced in order to enhance efficiency. At the same time, responsibilities between headquarters and its branches should be made clear. Headquarters focuses on control of the money supply, while its branches are responsible for and involved in financial supervision, settlement and research. With these, macro-control and supervision can be more effective. A banking legal framework should be pursued in order to set up accounting practices in the central bank and to make clear the relationship between the central bank and the budget, ensuring the normal functioning of the bank and compensation for its staff and eliminating incentives for pursuing profits. Interest and Exchange Rates Based on Market Forces To allow resource allocation and movement of factors of production by market mechanisms, a critical task is to make interest rates reflect supply and demand in Wu Xiaoling and Xie Ping 45 the markets as well as the creditworthiness of capital users. Rigid interest rates cannot respond to these requirements, and therefore, control of interest rates has to be liberalized gradually. Deposit and lending rates, together with bank and bond rates as well as interest rates on national debt and yields on other securities, should become flexible, in order to create conditions for the central bank to manage base money through open-market operations. Efforts will be increased to implement foreign exchange system reform and to make exchange rates be determined by market forces. Exchange and interest rates will be allowed to affect imports and exports as well as the overall balance of payments, in order to facilitate development in both the domestic and external sectors of the Chinese economy. Christopher Allsopp and Cyril Lin on Wu iaoling and Ie Ping 47 COMMENT ON "MONETARY POLICIES IN CHINA'S ECONOMY IN TRANSITION" by WU XIAOLING AND XIE PING Christopher Allsopp and Cyril Lin .1/ A. INTRODUCrMON The paper by Wu Xiaoling and Xie Ping makes important suggestions for improvements in monetary policy and monetary control in China that we largely endorse: the objectives of monetary policy need to be more clearly defined; the relative roles of monetary and fiscal policy need to be established; policy lending needs to be separated from other activities of the banking system; the duties and authority of the Central Bank need to be clarified; and the instruments of monetary policy (especially market-based instruments) need to be developed. This note comments in a general way on the underlying issues of monetary policy in China as well as on some of the more detailed suggestions. B. OBJECTVES It is easy to accept the argument, which is well made in this and in other background papers, that an excessive burden has been placed on the banking system and on the monetary authorities in China. Multiple and usually conflicting monetary policy objectives-of growth, of price stability, of stabilization, of decentralization and of industrial policy-make the task of the authorities extremely difficult. There are, however, dangers in signaling out one of these objectives (e.g., price stability) and one intermediate target (e.g., broad money, M2) as the principal domain for monetary policy. The need for caution arises because there are good reasons why monetary policy is called on to do so many things. Monetary policy and the banking system do actually impact resource allocation and efficiency as well as on many other aspects of the economy. Perhaps even more importantly, there may be serious limitations with other policy instruments (e.g., fiscal policy), which means that monetary policymakers cannot stand aloof when difficulties in other spheres of the overall economic policy arise. This is well recognized by the authors when they call for changes, especially regarding fiscal policy and policy lending, which would have to accompany monetary reform. Even if these changes ?re instituted, however, monetary policy is likely to remain a principle instrument of macroeconomic control. In the short term as well as in the .1/ Christopher Allsopp is a Fellow at New College, Oxford University, and Cyril Lin, Director, Centre for Modern Chinese Studies, Oxford University. 48 Comment longer term, as other countries have found, this will mean having regard to a number of policy objectives and indicators. That said, we wholly agree that monetary policy is, at present, called on to perform inappropriate tasks, such as policy lending. We believe that a fundamental problem in Chinese monetary policy derives not so much from the multiplicity of objectives per se, but from the fact that monetary policy and the banking system have been used to compensate for shortcomings both in the fiscal system and in the state-owned enterprise (SOE) sectors. On one hand, the government has found it difficult to reform SOEs and to improve their efficiency and profitability. On the other hand, fiscal and financial decentralization have reduced the (central) government's control over financial resources, thus reducing its ability to finance subsidies and other support for loss-making SOEs through the budget without incurring a visible and sizable deficit. Consequently, expenditures for supporting SOEs as well as other types of policy lending (e.g., industrial restructuring) have been loaded on to monetary policy and the banking system. A significant proportion of the expenditures financed through the banking system that properly belong to the fiscal system are nondiscretionary. Support for loss- making SOEs, for example, entails spending on what in the West would constitute, among other things, unemployment and other social security benefits (e.g., health care, housing, pensions). Where a large proportion of "bank loans" to loss-making SOEs are nondiscretionary, then a large component of the growth in money supply and in credit are "nondiscretionary," leaving monetary policymakers with insufficient room to maneuver. Under present circumstances in China, it is whether any substantive progress in monetary policy and banking system reforms can be made without simultaneous reforms of SOEs. It is important to recognize the microeconomic sources of macroeconomic instability/ imbalances in China, and to recognize that problems in monetary policy and the financial system are, to a large extent, the result of systemic and policy weaknesses that lie elsewhere. C. SYSTEMIc FEATURES OF CHINESE MONETARY EXPANSION The difficulty of formulating monetary objectives for China is dramatically illustrated by the rise in broad money as a ratio to GDP from about one third in 1978 to over 100 percent now. This buildup has occurred over a period that has, on the whole, been one of moderate price stability. (This is not to deny that excessive liquidity may have been a factor behind inflationary pressures in certain periods, such as in 1988.) This buildup is only in part a result of monetization.2/ The main reason for this phenomenon is the pattern of intermediation and the ownership structure in China. As referred to in the background paper, reform has been accompanied by massive changes in the pattern of financing, with the government's role in investment shrinking and that of enterprises rising. More recently, there has been an 2/ The authors of this note are indebted to Jin Lizuo, whose doctorate thesis contains much more information and analysis of these issues. Christopher Allsopp and Cyril Lin on Wu Xiaoling and Xie Ping 49 enormous rise in household (especially urban household) saving, which is effectively recycled to borrowing enterprises through the banking system. (The background paper suggests that although the capital market has developed recently, it only accounts for 8 percent of financing.) Savings are closely related to bank deposits since, effectively, there has been little else that can be owned in China. With, effectively, a single channel of intermediation and a single asset (bank deposits), the sectoral balance identities (see Guo Shuqing and Han Wenxiu, Zhongguo GNP di Fenpei he Shiyong, 1992) imply most of the features of the Chinese financial system that so worry monetary policymakers: rapid expansion of credit and money, enterprise deficits and, at a more subtle level, poor profitability and dangerously weak banking sector balance sheets. The positive feature is that household savings, closely related in China to the demand for broad money, appear to have been voluntary and willingly held. There is a clear liquidity risk, however, for the future. While this pattern persists, there is effectively no way of stopping rapid monetary expansion. (Cutting the expansion of broad money would involve cutting household savings, which experience suggests is difficult and which is, in any case, not desirable.) Luckily, the broad lines of needed reforms are obvious and fit in well with Chinese policy objectives. Wat is needed is the development of channels of intermediation outside the banking system involving new types of lending and ownership. These channels are already developing, and further changes are proposed in the background papers. Effectively, the relative importance of the banking sector in financial intermediation needs to shrink. With a smaller role for the banking system, the task of monetary control would become easier. There is, however, a danger that must not be ignored: this is that firmer monetary control might be established at the expense of less macroeconomic control. Alternative channels of intermediation that are developed might allow enterprises to avoid the controls that presently exist, exacerbating problems of potential instability and inflationary pressure. It is imperative that regulatory systems and alternative policy instruments are developed explicitly to counter these dangers (we discuss this later) .3/ D. FISCAL POLICY AND POLICY LENDING 3/ The problems for macroeconomic control arising from diversification of the channels and modality of financial intermediation are already evident in China today with the rapid growth of capital markets and other types of assets (e.g., property). In 1988/89, the government was able to drastically curb investments through administrative controls over the banking system ("yi dao jie" or "cutting with one stroke of the knife"). With financial disintermediation occurring (outside the banking system) through a large number of (essentially unregulated and unsupervised) nonbank financial institutions, the government's ability to curb lending and investment might today be less effective. 50 Comment One of the major reasons for excessive growth of bank loans and money in China is that there is insufficient involvement of the central government budget in investment spending. This phenomenon is referred to in a number of the background papers. Although reforms have decentralized control over financial resources and investment decision-making powers to the localities, the latter has tended to neglect certain important types of investment, largely because the incentive structure (of the fiscal system) and the peculiarities of the property rights system have not been conducive to it. Nevertheless, these projects-such as in basic industries and infrastructure-had to be financed from somewhere. The central authorities were faced with the alternatives of financing this investment through the budget (either via increased taxes or through a deficit) or by encouraging so-called policy lending through the banking system. They have decided to adopt the latter option with adverse consequences for monetary control and fragility of the banking system. It is evident that policy lending should be handled some other way. What policy lending does is add an increment of loan-financed investment and an increment of deposits within the banking system. (In an obvious notation, dl = dL = dD.) This may or may not cause problems. One possibility is that with this component of investment (financed through policy lending), loans and deposit expansion simply crowd out other components. This would theoretically be the case if aggregate credit ceilings were enforced or if the banking system were tightly restrained by reserve ratios. In this case, other loan-financed expenditures and deposits would fall in an offsetting manner. Another possibility is the excessive creation of credit, particularly if the central authorities find it difficult to withstand pressures for accommodation from local governments and bank branches. (See our earlier point concerning "nondiscretionary" credit.) It is suggested in the background paper that, in practice, there is systematic overshooting of targets and policy lending adds to an expansion of loans from the central bank. This seems highly plausible. It is necessary to be very clear, however, precisely what the problems are that need to be addressed. One possible problem is that the addition of policy lending might lead to investment and credit being excessive in relation to the supply potential of the economy and the willingness of the households to save. Equivalently, investment would be running ahead of potential savings. This is a real problem and not just a monetary one, and the solution has to be reduced spending (in practice, either reduced investment, or reduced lending for subsidizing loss-makers) somewhere. A quite different problem arises if savings are adequate: there could still be a problem arising from the liquidity counterpart of the investment-i.e., from the liquidity of the deposits. These different problems need to be kept in mind when possible solutions are debated. The suggestion in the document is that policy lending should, in part, be the responsibility of the budget and, in part, should be hived off to a new set of institutions lending for particular purposes and financing the lending by government-guaranteed bonds. Apart from institutional details (and accounting) the latter would, in economic terms, be almost identical to taking this expenditure back onto the budget and financing it by bonds. Christopher Allsopp and Cyril Lin on Wu Xiaoling and Xie Ping 51 We would endorse either of these reforms. The main advantages would be (a) that the banking system would be no longer involved and (b) that the counterpart to the increased expenditure would appear as (less liquid) holdings of bonds rather than as deposits. A cosmetic advantage would be that broad money would grow less rapidly and the real advantage would be that the asset structure of the economy would be less liquid.!/ Beyond this, and perhaps most importantly, the explicit attention to this type of lending and expenditure would surely improve the transparency of the system and the possibilities for control and monitoring. The bonds or other assets used to finance policy lending would have to be sold outside the banking system. If they were sold to the banks, this would just substitute one form of bank lending for another, and there would be no effect on deposit formation. The main worry we have with this type of proposal is that, desirable as the changes would be, they should not be seen as necessarily solving the underlying systemic problem. It would (as the background paper notes) be necessary to alter targets for credit expansion and money appropriately (to make room for the expenditure financed in a different way). The pressure to exceed targets and to finance investment would continue and so the pressure on the central bank to give way to demands from local areas. The fact that money and credit expansion would look less extreme might, paradoxically, lead to less discipline rather than more. Nevertheless, the potential for control should be improved: ultimately, however, policy and nonpolicy lending do need to be curtailed and the efficiency of both needs to be improved. E. CAPrfAL MARKETS AND OTHER FORMS OF INTERMEDIATION The same general principles and qualifications apply to the development of other forms of intermediation outside the banking system. They are desirable, but there is a danger of weakening of control and the new channels need to be closely supervised and monitored (by the central bank or by other institutions set up for the purpose under the central bank). The supervisory structure is important per se, but, beyond this, the obvious point is that macroeconomic control and stabilization will require instruments capable of influencing expenditures financed in this way. If the problem is seen as involving the provision of assets for the "nonstate sector" to hold as ownership reform proceeds, it is clear that the process ought to go beyond capital market development in the narrow sense to include property rights in real estate, pensions, insurance and so on. Institutional development in these areas is likely to !/ The suggestion that the economic effects would be similar between a new policy lending institution and finance through a bond-financed budget deficit needs some justification. In accounting terms, there could be a difference. The institution would build up claims on those it lent to, whereas with direct budget finance (i.e., not loans), there would apparently be no claim. In practice, however, the government would own any future revenues that accrued from its investment, and, for the institution, if it were involved in supporting loss-makers, formal claims would, economically, be valueless. Needless to say, the behavior of the provider of funds and of the receivers would depend, to an extent, on the institutional details. 52 Comment be particularly important; the establishment of institutional investors could offer advantages for long-term financing of investment in infrastructure and basic industries, for corporate restructuring, for company control structures conducive to efficiency and for a corporate governance market. F. TuE BANKING SYSTEM The paper by Wu Xiaoling and Xie Ping makes a number of suggestions for improvements in the functioning of the specialized banks. This is obviously a crucial area that needs to be discussed in detail. Commercialization will involve major changes that will become easier if their role is more closely defined. Here we want to make several points. (a) As far as households are concerned, the banks need to provide a wider range of financial service, especially checking deposits, loan finance, etc. Here, too, there are trade-offs between liberalization and commercialization on one hand and control or stability on the other hand. At the moment, household deposits are relatively illiquid and, in current circumstances, this is an advantage. Such reforms may need to be accompanied by the development of a wider range of nondeposit financial and other assets to be held by households. In other words, commercialization of this aspect of the banking system needs to be approached cautiously and needs to go with the wider reforms (referred to above) in general and with regulatory and due diligence frameworks in particular. (b) Specialization of banking function has its advantages, but a commercial banking system will require much competition between essentially similar financial institutions, including competition between the specialized banks in a number of areas. (c) The regulatory system needs to be tightened up both because it is desirable in itself, and because it is this that would provide the basis for macroeconomic control. (d) The concern over the development of other channels of intermediation should not be allowed to divert attention from the point that banks may be the most efficient way of channeling funds to particular areas. There are many historical examples where banks have been crucial in successful industrialization. The merits and demerits of bank versus stock market- based financing, and their implications for issues such as "short-termism" (myopia), corporate governance (e.g., outsider versus insider control), etc., require urgent consideration. G. TuE ROLE OF THE CENTRAL BANK Christopher Allsopp and Cyril Lin on Wu Xiaoling and Xie Ping 53 We endorse the point that the role and authority of the central bank need to be clarified. It clearly needs more operational autonomy and clear (and fewer) objectives. The functional classification suggested seems sensible. Monetary and macroeconomic policy formulation and implementation can, to an extent, be separated from the other roles in the supervisory and regulatory areas. The supervisory and regulatory regime is crucial and needs to be designed with a view to strengthening indirect control over the activities of the specialized banks and other financial institutions. It seems to us that similar points apply to the developing capital market and other channels of intermediation and liquidity creation. It is essential that these developments do not lead to instability and loss of macroeconomic control. The motivation for financial reform is not just efficiency and improved resource allocation, but to strengthen overall macroeconomic control. There are recent examples from the industrialized countries where financial liberalization has led to large changes in spending and to speculation, posing major difficulties for policy (Japan, the United Kingdom, Australia). Responsibility for supervision and regulation could be vested with the central bank or with institutions concerned with particular sectors. The phasing and sequencing of reforms and liberalizations is obviously the concern of general macroeconomic and reform strategy. The issues of central bank independence and of improving monetary policy discipline were addressed in our paper presented at the UNDP/World Bank/SCRES/PBC- sponsored conference on "Financial Sector Reform in China," held in Hainan, December 16-20, 1991. Here, we would simply like to reiterate a couple of points from that paper: (a) PBC in China ought to enjoy greater autonomy in operating monetary policy (which may be determined by the State Council) so as to enhance monetary policy discipline and consistency;5/ and (b) the organizational setup of PBC needs to be reformed to allow it to withstand interventionist pressures (from local governments and central government ministries) for accommodation. The possibility of establishing regional banks, somewhat similar to the Federal Reserve System in the United States, is also something that we believe merits consideration. H. POLICY INSTRUMENTS AND MACROECONOMIC COORDINATION The background paper advocates improving the instruments of monetary policy and of indirect macroeconomic control, suggesting especially the increased use of open-market operations and a move toward more commercially determined interest rates. Both of these, it is suggested, would help in controlling base money in a more autonomous way. One problem repeatedly referred to is the predominance of credit in enterprise finance. This means that monetary policy via direct or indirect credit control is potentially very powerful but also very hard to institute (effective measures promote 5/ Operational autonomy here would be somewhat analogous to that given to SOEs: PBC would be mandated to achieve certain targets. 54 Comment strong resistance!). This control will be weakened with the development of alternative channels of intermediation, and we have already referred to the need for equivalent controls to be exercised elsewhere-which puts a heavy responsibility for macroeconomic policy on the fiscal authorities. (The establishment of a government financing framework is their preferred coordinating mechanism, but much would depend on the details of how this is operated in practice.) The use of base control, or other versions of reserve ratio control, is effectively a way of imposing aggregate credit constraints while leaving the details of allocation to the banking system. Even assuming that aggregate control of this kind can be made effective-and the pressures to finance excessive lending would surely remain- there are serious problems of the allocation of credit (many of which, such as regional priorities, are mentioned as difficulties in the paper) that remain to be solved. Since the banking system and the credit mechanism are going to remain important, the banking system can hardly avoid involvement in these difficult decision areas. Commercial criteria can hardly be relied upon, not just because the banks are not presently commercial, but also because that would presuppose that the underlying problems had been solved elsewhere-which is unlikely. Reform of monetary policy and the banking system-along the lines indicated both in the background paper and in this comment-are aimed at improving monetary control and the efficiency of the banking system. But the establishment of alternative channels of financial intermediation could weaken macroeconomic control unless the basis for such control-regulatory frameworks for financial activities-are put into place early on and strictly enforced. More importantly, however, is that the demand for funds in the Chinese economic system are likely to remain very great, and monetary and banking reform alone will not address this problem arising from factors in other sectors of the economy (e.g., SOEs as a microeconomic source of macroeconomic instability, the investment hunger of local authorities and their imbalanced pattern of investment deriving from ambiguous property rights and from incentive structures in the fiscal system). In other words, improved control over the monetary and banking system might simply lead to these pressures emerging elsewhere. The challenge therefore is to strike compromises and balances in reform that are conducive to allocative efficiency while preserving, or indeed improving, the government's capacity to main control.6/ In the short to medium term, this might well require a combination of direct and indirect market-based instruments in monetary policy, as well as their synchronization with fiscal and other policy instruments. This means that there may well be "lumpiness" or indivisibilities in reforms, with monetary and financial reform requiring concomitant reforms in SOEs, social security, housing, etc. We strongly endorse Zhou Xiaochuan's argument on the imperative for an integrated reform program. 6/ An immediate example of the challenge in striking comprises concerns the problems of growing economic differentiation among different regions in China. Ideally, one would like to be able to adopt, in a sense, different monetary policies for the more-developed, marketized and faster-growing (coastal) areas and for the poorer, less-dynainic inland areas. The task then would be to design, for example, differential policies that are nonarbitrary and least distortionary. Christopher Allsopp and Cyril Lin on Wu Xiaoling and Xie Ping 55 The final and obvious point here is that one must avoid going from one extreme to another extreme: monetary policy in China today may be called upon to perform far too many functions, but reforms should not be unrealistic by aiming for single or excessively narrow objective(s) and target(s). It is a principal instrument of macroeconomic control, but it is only one and needs to be employed jointly with an array of others. Liu Kegu 57 MARKET ECONOMY AND MACROCONTROL OF FINANCE Liu Kegu Il A. INTRODUCTION Fiscal reform has achieved great progress in the last 14 years, resulting in increased strength of state finances. However, the prevailing financial structure, financial ability and macrocontrol of finance are not sufficient to meet the requirements of a market economy. Therefore, it is urgent for us to analyze problems, unify thoughts, determine direction, and grasp opportunities to speed up financial reform, actively adjust fiscal policies, establish a new fiscal structure and a new policy structure. At the same time, we should enhance the macrocontrol of finance, promote the formation of a socialist market economy and achieve a coordinated, stable and highly developed national economy. B. FISCAL PROBLEMS AND DIFICULTIES Contracted Taxes The widespread contract system for enterprises did play a positive role in increasing incentives for enterprises at one time. However, the income tax is contracted, taxes and profits are all mixed up together, contract rates vary, and individual negotiation is common. As a result, the budget restraint of enterprises is softened, the growth of fiscal revenue is restricted, and all of this hinders competition among enterprises. Although the contract system for local finance provides an incentive for local finance bureaus to raise revenue, the mechanism for increasing local revenue has been strengthened, the increase of central revenue has been constrained, and the adjustment function of taxation as an equalizer of industries and product structure has been weakened. Therefore, the problem of excess capacity is exacerbated and presents a hurdle to the establishment of a unified market. The distribution of gross national product (GNP) is continually growing for individuals. In the final distribution of GNP, the proportion of the state, collective organizations (including state-owned and collective enterprises and units) and individuals was, respectively, 33, 10 and 57 percent in 1980, but 16, 11 and 73 percent, respectively, in 1990. Meanwhile, the unfair distribution among individuals has also become worse with each passing day. Extrabudgetary funds have grown as a share of the total, which creates unsystematic circulation. Moreover, various kinds of funds collected and managed by different departments on their own have increased steadily, which is beyond the control of 1/ Liu Kegu is deputy director of the System Reform Department of the Ministry of Finance. 58 Market Economy and Macrocontrol of Finance a unified financial structure. As a result, financial capacity and financial power are decentralized and the distribution function of finance is weakened. Irrational Financial Resource Structure By 1992, nonstate-owned enterprises comprised more than half of all enterprises. However, the industrial and commercial tax they paid was only a little more than 30 percent of the total. In the last 10 years, tertiary industry has developed at a rate higher than that of the entire national economy, but the financial revenue it has provided has been comparatively low. The real estate and security exchange businesses have developed very fast, yet with little taxation. Meanwhile, personal income has increased very fast, but the levy of personal income tax is very poor. The structure of financial resources has thus not been adapted to the change in economic structure, being still mainly dependent on the state economy, traditional industries and enterprises. The ratio of retail sales to taxes, the ratio of capital profit to tax and the rate of return on capital have all declined. The proportion of enterprises that recorded losses was 10.7 percent in 1985, but this increased to more than 30 percent in recent years. Subsidies The finance bureau is responsible for providing subsidies for loss-making enterprises. In 1992, the total subsidy was Y 44.6 billion, which is Y 20.1 billion more than the Y 24.5 billion of 1985. The annual average rate of increase was 9 percent. The price subsidy in 1992 was Y 32.1 billion, which is four times the Y 7.9 billion of 1978. From 1981 to 1991, the annual average rate of increase of administrative expenses was 16 percent, while the rate of increase of financial revenue at that time was 6 percent. Enforcement of Tax Legislation Although the creation of financial legislation has made some progress, recently the problem of not abiding by the law and not affixing responsibilities in the violation of laws is getting worse and worse. Some regions promulgate various preferential policies on finance and taxation on their own, and exceed their power in tax exemption. They grant tax refunds at will and contract the turnover tax. Moreover, the management of tax collection is not strict; therefore, tax evasion is very serious. The restraint on expenditures is softened, inspection is inefficient and the phenomenon of waste is very common. Growing Budget Deficit Since 1978, most fiscal years have seen deficits. In 1992, the hard deficit reached Y 23.7 billion, which is seven times the Y 2.5 billion of 1981. In 1992, local finance bureaus incurred Y 3 billion in deficit, which gives a very dangerous signal. If we could calculate the deficit according to international practice, that is, include debt income in the deficit, the soft deficit in 1992 was Y 90.5 billion, 3.8 percent of gross Liu Kegu 59 domestic product (GDP) for that year, which is higher than the usually considered "safe" level of 3 percent. By the end of 1992, total domestic and foreign debt had reached over Y 500 billion. From 1978 to 1990, the annual average rate of increase was 13.9 percent, while the average rate of increase of fiscal revenue (excluding debt income) was only 8.2 percent, a difference of 5 percent. In 1992, the proportion of domestic financial revenue in GNP was about 19 percent, which is generally about one third of the average level of other countries. The proportion of central financial revenue (excluding debt income) in total financial revenue uf the country is 38.6 percent, which is much lower than the general level of 50 to 60 percent in other countries. The proportion of debt income in total expenditures in central finance has reached 47 percent. Such a weak financial status has reduced the macrocontrol ability of central government substantially. If we do not have an appropriate evaluation of the seriousness of the results that have been achieved and will be achieved, we will make an historic mistake. C. THE FUNCTION OF FINANCE IN MACROMANAGEMENT In recent years, economic development and financial difficulties have coexisted, which shows that the financial difficulties are not caused by the economic recession, but by the difficulties of the system. There are various reasons to explain this situation. One important reason is that people have not acquired sufficient knowledge of the position and role of finance in a market economy, as well as the function of finance in macrocontrol. The old planning and fiscal system have always been the target of economic system reform. The main pattern is decentralization of rights and transferring of interest, which is absolutely necessary and correct in a certain historic period and to some extent. However, we will make mistakes continually if we deny the new function and role of planning and finance in the new system, if we only conduct adjustment from a quantitative point of view and neglect the reform of qualitative changes, if we only attach great importance to incentives and liberalization and overlook restraint and control. Now that we have set the objective of establishing a socialist market economy system, we should fully understand the macroeconomic management function of government, and the position and role of finance under a market economy, abiding by the scientific theory created by human civilization, drawing on the successful experience of mature market economies and combining this with our actual situation. There are seven fundamental functions of finance under a market economy: (a) Secure the needed capital for the construction of political and social management of the state. Guarantee the independence and safety of the country. Ensure social stability, including improvement of the social insurance system and realize full employment. This is the basis for economic development. (b) Create a healthy operation of the market economy. Assure the free movement of commodities and means of production. Guarantee the free operation of enterprises and private individuals, as well as the equalization of the price, taxation and financial systems. Ensure full competition, 60 Market Economy and Macrocontrol of Finance guarding against monopolies. Guarantee the solemnity of contracts, as well as the unification, impartiality and stability of market operating rules. Try to promote the development of a large market. The above comprise the foundation for the operation of the economy and macrocontrol. (c) Adjust the social and economic structure. Encourage the development of education, science and technology, as well as infrastructure, energy, transportation and raw materials. Encourage the good quality, capability, high efficiency and honesty of the government. (d) Promote the coordination and equalization of development of various regions. Increase the general efficiency of use of state resources, and achieve the common development of various areas, the solidarity of various nationalities and the unity of the state. (e) Rationalize the distribution structure of national income, coordinate the relationship between the state and enterprises, society and individuals, production and consumption, fairness and efficiency, short-run and long-run, rich and poor, etc. (f) Streamline the social supply and demand relationship, as well as the economic development cycle. Make comprehensive use of the monetary policy and the fiscal policy, in order to avoid excessive periodic fluctuations and make full use of limited resources. (g) Protect the resources of the country and secure appreciation of state assets. In order to develop the above functions fully and give free rein to finance in the new system, the first step is to achieve a rational distribution of tasks and close coordination among the macroeconomic management departments, such as finance, planning and banking. Second, speed up basic changes in the concepts, functions and management patterns of finance itself, which include the following aspects: (a) Change from management over state-owned enterprises and assets to various forms of enterprises, industries and all kinds of economic cells, including enterprises, administrative entities, legal persons (corporations) and private individuals; (b) Transfer excessive management over the microeconomy into macrocontrol; (c) Change from interfering in the internal affairs of enterprises to inspecting the external affairs of enterprises; (d) Shift direct administrative measures into comparatively more indirect management patterns by use of economic levers; Liu Kegu 61 (e) Change from solely government behavior into the dual function of government and social organization, making full use of accounting firms, law firms, commercial associations and stock exchanges; (f) Change personal control to management according to law; (g) Transfer the erratic decision-making pattern into a standardized stable situation that attaches great importance to rules and experience; (h) Change from control over short-term activities into looking at long- and medium-term activities; (i) Change from mainly balancing the budget into promoting economic development; (j) Switch from attaching importance to superficial adjustment to, instead, focusing on fiscal system reform. D. REFORM, ADJuST AND STRENGTHEN THE MACROMANAGEMENT FUNCTION OF FINANcE Central Government Functions The economy is the foundation of finance. In agriculture, the government should guarantee various supporting policies to agricultural industry and increase agricultural inputs. Government should make efforts to improve large- and medium-size state-owned enterprises, increase retained funds of enterprises, enhance the technical updating capability and improve loss-making enterprises' ability to make a profit and reform their operating mechanisms. Supporting the development of tertiary industries, such as transportation, communication, commercial services, financial insurance, information consultation, tourism, etc., is also important, as is science and technology and the promotion of the commercialization of scientific and technological achievement. In accordance with the changes and trends that have occurred in the ownership structure, the industrial structure, as well as the distribution pattern of GNP, we should adjust the tax structure and enlarge the tax base. Support to the development of village and township enterprises, guidance of the healthy development of individually owned and privately owned enterprises and joint ventures, and an increase in the proportion of financial revenue of nonstate-owned enterprises in total revenue are all to be encouraged. It is necessary to develop new financial resources, such as revenue from sale of state-owned land and real estate, royalties from mineral and sea resources, and charges for transactions in foreign currency and securities, etc. A number of small-size state- owned enterprises can be sold via auction or leased. 62 Market Economy and Macrocontrol of Finance Separating Taxes and Profits A trial attempt at separating taxes from profits has been carried out in 2,500 enterprises in 35 areas and central departments of the country. Based on the experiments and lessons of this trial, we suggest a package of measures be implemented in order to rationalize the relationship between the state and enterprises. The general idea is to abolish policy discrimination based on the difference of ownership, area and Chinese or foreign funding; to do away with all irregular methods and try to approximate the international standard; to unify the tax rate, tax base and financial accounting system; and, as a result, promote fair competition and the stability of policies. The concrete measures proposed are as follows: (a) Introduce an identical tax rate of 33 percent or 30 percent + 3 percent (base rate is 30 percent, local independent rate is 3 percent). For those enterprises that make less profit, a lower preferential tax rate could be implemented for a certain period. (b) Complete the reform of abolishing servicing principal payments on loans before paying taxes. (c) Cancel the "energy and transportation funds" and the "budget regulating funds." (d) Execute the "General Financial Rules for Enterprises" and "Accounting Standards for Enterprises"; practice the registered capital system; and increase the rate of depreciation. Interest on fixed-asset investment loans, bonuses and technology development expenditures would all be considered costs. The policy of drawing 10 percent of sales revenue as a technology development fee and supplementary current funds would be abolished. (e) Profits will be distributed according to invested capital and dividends shared according to shares. For the enterprises that abide by industrial policy, most or all of profits after tax can be retained during a certain period. (f) Do away with the policy of rebating 40 percent of the income tax of retained profits used for reinvestment for production purposes. Change the policy lending by banks into state investment. For enterprises that do have difficulties in repaying the "old loans" of common commercial banks, deferred payment could be adopted. "Dead loans" could be written off by the banks, while increasing the bad debt reserve rate. (g) Gradually abolish the operational loss subsidy to enterprises, and reduce the policy loss subsidy. Lia Kegu 63 By implementing the above-mentioned policies, the retained capital for most enterprises would be increased substantially, and repayment ability increased an estimated 30 percent. The amount of fiscal revenue will increase following the impact of the reform and the raising of efficiency of the enterprises; therefore, this reform should be expedited. The target period to carry out this reform is 1994 for state-owned industrial enterprises, 1995 for state-owned business enterprises, and 1996 for all enterprises within China. Central vs. Local Taxes In 1992, nine areas began to experiment with the tax-sharing system. The current experiment has many shortcomings that should be improved as quickly as possible. By utilizing international experience, the new system should be designed to give incentives to both central and local governments, streamline their economic behavior and make the central part of the incremental revenues increase progressively, thereby raising the percentage of central fiscal revenue in the total. The following problems should be resolved: (a) Set up scientifically and legislate the functions and their corresponding authorities of the governments at various levels, and determine the fiscal expenditures of various levels of government; (b) Determine the fixed revenue of the central and local governments mainly by tax categories, and decrease the proportion of shared revenue; (c) Decentralize the local tax authorities and perfect the local tax system; (d) Determine the local expenditure base mainly by using the factor method; (e) Abolish the principle that the financial revenue be delineated according to the direct ownership relationship of the enterprises (subordination); (f) Set up a national tax system, and establish the administrative agencies of national and local taxes separately. In our view, central government revenue should account for about two thirds of the total, while local expenditures would account for about two thirds of total expenditures. This reform will touch upon the vested interests of local governments and must take the national interest into account, seeking common understandings. The options should be perfected in 1993 and put into practice in 1994, or 1995 at the latest. 64 Market Economy and Macrocontrol of Finance Dual Budget System In 1992, the central budget was calculated according to the "dual-budget" system, and the provincial budget will also be prepared in this way in 1993. In practice, the constraints on current expenditures should be hardened in order to maintain a reasonable scope and structure of the construction budget. "The Implementation Method for Preparing the National Dual-Budget System," which stipulates the preparation, implementation, adjustment, general accounting calculation and categories of revenue and expenditures of the dual budget system, should be promptly circulated to facilitate standard operations. A more effective and perfect way to prepare the dual-budget system should be further studied and established. Since the government acts as both social administrator and owner of state-owned properties, the budget can be considered to be divided into three parts: (a) Public Budget. The revenue comes from the taxes the government receives as the social administrator and expenditures are those of the administration as well as public expenditures including public welfare and social security. (b) Capital Budget. The revenues are the surplus of the public budget and state-owned operating capital profits; the expenditures are capital investment and loss subsidies to state-owned enterprises. It may harden the budget restraints to the state-owned enterprises to facilitate raising the operating efficiency of state-owned capital. (c) Policy Investment and Financing Budget. The revenues include public budget surplus, revolving funds of fiscal credit, national debt, bank borrowing, postal savings, pension fund surplus and the policy investment incomes, as well as the repayment of loans. The expenditures are policy- oriented investment and loans. This will encourage the separation of policy loans from commercial loans, assist the People's Bank of China (PBC) to be "centralized" and the specialized banks to be commercialized. In doing so, it will also help to strengthen macromanagement over financial business and improve the efficiency of commercial loans, facilitate the transfer of enterprises' operating mechanism, and hence raise the macromanagement and adjustment capability of the fiscal departments and increase the extent of industrial restructuring. Tax System Reform The objectives of tax system reform are: (a) To create a environment for enterprises to compete fairly; (b) To ensure national fiscal revenues; and Lia Kegu 65 (c) To play fully the role of tax as a leverage of macroeconomic adjustment. The principles of reform are: fair, open, simple, unified, standard and stable. The broad thinking of the reform: low tax rate, broad tax base, fair treatment and efficient management. The basic judgments for the tax policy should be as follows: the tax should be neither ownership-oriented, nor area-oriented (but maintain preferences to a few specialized zones for a limited time), nor Chinese or foreign capital-oriented, nor enterprise operating mechanisms-oriented, nor enterprise "difficulties"-oriented. The main factors for absorbing foreign funds shall be political stability, economic growth, product markets, infrastructure, production factors, legal environment, government efficiency and economic policies. By and large, the tax should not be based on the scope of enterprises. The tax system should be designed as industry-, sector- and product-oriented. The main tax categories will be product taxes or a consumption tax and not the value-added tax nor income tax. For individual income and property, we will develop the individual income tax, inheritance tax and gift tax. Tax policy in a market economy should be neutral. The main contents of the proposed reform are as follows: (a) Set up a comprehensive tax system mainly consisting of indirect taxes supplemented by direct taxes. (b) Establish a turnover tax system with value-added tax, product tax and business tax. The value-added tax should be used in industry and commerce. Product taxes (such as on cigarettes) would be used to meet certain policy objectives. The business tax is to be applied to nonmerchandise operating business, such as services; (c) Unify the turnover tax for domestic or foreign enterprises, enterprise income tax and individual income tax; enhance the scope of resource taxes and property taxes; start new taxes such as gasoline consumption tax, inheritance tax, gift tax, etc., and the unified social insurance tax also should be started when appropriate. (d) Enhance control over tax collection. Separate legislative power from execution of taxation laws, as well as the stipulation, explanation and execution of taxation policies. The legislation of main taxes is concentrated at the central government. The right for exemption of main taxes should be in the hands of central and provincial governments, among which exemption to the turnover tax is under the control of central government. Cancel all forms of turnover tax contracts. Penalize those who are tax cheats and tax evaders. Enhance tax collection management over foreign-invested enterprises, village and township enterprises, private enterprises and individually run enterprises. Increase the personnel who are involved in tax 66 Market Economy and Macrocontrol of Finance collection, improve their quality and establish an inspection information system on tax collection. Reduced Overhead Expenditures Combined with price reform of grain, cotton, edible oil, meat, vegetables, egg, coal and petroleum, we should reduce substantially and finally eliminate price subsidies and subsidies for losses incurred from policy lending. In line with foreign trade reform, we should eliminate all import subsidies. It is necessary to reduce administrative expenditures and lower their growth rate substantially. Part of the work of present government agencies should be eliminated, in order to reduce public expenditures. Reform of the Management System for State-Owned Assets Two steps are necessary. First, separate the social administrative authority of the government from its management authority over state-owned assets. Second, separate the government as owner of state assets from the daily operating rights of enterprises. State ownership of assets can be combined with the market economy through flexible and effective asset management corporations, such as the joint-stock system. Reform must suit the fundamentals and regulations of modem management practices. There are mainly two aspects: one is the simplicity and continuity of the ownership responsibility; the other is unity of liability, rights and interests in various levels. This requires the streamlining of the liability, rights and interest relations among the People's Congress, State Council, Ministry of Finance, State Assets Administration, Sectoral Ministries, Assets Management Intermediaries, Enterprises, Supervision Committees, boards of directors, managers and staff. Supervision systems that consist of Parliament, government auditing and public accounting over the state-owned assets should be established. The commercial targets of enterprises should be separated from social targets set by the government. Considering the economic efficiency of the enterprises and the fundamental role of state-owned enterprises, state assets should be withdrawn from some sectors and invested into the more priority sectors. The state-owned enterprises should be classified, and then different management and operating patterns applied. The state-owned enterprises should be allowed to go bankrupt. The state asset managers of the government should be trained to become group enterprise managers. Liu Kegu 67 Others The management of national debt should be strengthened. Financial accounting system reform can be facilitated by increasing the number of accounting firms and certified public accountants. The housing and social security system reform should be promoted. The creation of fiscal legal systems should be pursued. Finally, relationships among the planning, fiscal and banking systems should be streamlined so as to improve macroeconomic management and adjustment. Xu Shanda and Ma Lin 69 MARKET ECONOMY AND TAX REFORM IN CHINA Xu Shanda and Ma Lin I/ A. INTRODUCTION It has been more than a dozen years since China started thinking about restructuring its tax system and constant efforts have been made to implement and improve the reform. As a result, a complex tax system with turnover taxes and income taxes as the main revenue sources, supplemented by other minor taxes, has been established. The system basically answers the needs of development of the economy and reform of the economic structure of the country. B. THE ROLE OF TAXATION IN A SOCIALIST MARKET ECONOMY The market economy is an economic system whereby economic operations are organized via market mechanisms and the market plays a basic role in resource allocation. Under socialist market economy conditions, taxation is a means by which the state participates in the redistribution of social products and raises public revenue, as well as being a macroeconomic lever directly controlled by the state to regulate social production at all stages. It plays a role that no other administrative measure or economic lever can replace. With the transition from a planned economy to a market economy, those formerly heavily relied-upon regulating means such as administrative orders and mandatory plans will be reduced substantially and the macroregulating function of some economic levers such as pricing will also be weakened. However, a series of fundamental issues in the socialist national economic operations such as the overall balance of the economy, the readjustment of industrial structure, the maintenance of an equitable competitive environment and the alleviation of unequal social distribution remain to be solved through nonmarket mechanisms, namely the state's macroadjustment means. Given this condition, taxation will undoubtedly become one of the most important macrocontrol means of the state in a socialist market economy since it possesses both legal status as well as economic regulating functions. Generally speaking, taxation plays the following main functions in a socialist market economy: guaranteeing the healthy operation of a market economy, promoting the formation and perfection of market mechanisms, regulating social distribution for the purpose of reaching common prosperity and limiting the negative effects of a market economy. The effective functioning of taxation in a market economy requires the following basic conditions: (a) All stages and the whole process of social reproduction including production, distribution, exchange and consumption and all economic 1/ Xu Shanda and Ma Lin are both deputy directors in the Policy Department of the General State Bureau of Taxation. 70 Market Economy and Tax Reform in China activities must be directly or indirectly placed within the market relationship. Markets are the fundamental operating mechanisms regulating the whole social economy, pushing the flow of productive elements and guiding the distribution of resources. (b) All enterprises must possess the autonomy to run their own businesses and shoulder the obligation of paying taxes in accordance with the law and the responsibility of accounting for their own profits and losses. Being separate producers and managers of commodities, they are the main body of the market. They conduct business through monetary transactions. (c) The government does not directly interfere with the day-to-day affairs of production and management of enterprises, but rather regulates and standardizes the operational activities of enterprises via financial, taxation, price and banking policies. (d) All business operations must be conducted in accordance with laws and regulations. The entire operation of the economy must be placed on an appropriate legal basis. The reform of China's tax system must conform to the basic characteristics and rules of a market economy. The market is uniform; therefore, tax legislation must be unified. The market is open; therefore, the tax structure and tax administration must be adapted to the needs of opening-up and be aligned to common international taxation norms. The market is competitive; therefore, taxation policy must reflect the principle of equitable tax burden. The market operates in conformity with objective economic rules; therefore, taxation should play a greater role in strengthening macroregulation and promoting a better micro-environment. It should be noted that despite the outstanding achievements China has attained in restructuring its tax system over the past few years, the system as it is today cannot entirely cater to the needs of the market mechanism, both structurally and functionally. Since China is gradually but assuredly changing to a market economy, more fundamental tax reform is needed without delay. C. THE BASIC PRINCIPLES GOVERNING TAX REFORM Viewed from the practices of China and the experience of other countries, creation and reform of the taxation system under the conditions of a market economy must follow the following basic principles: (a) The Principle of Effectiveness. A scientific taxation system is the basis on which taxation can correctly and effectively play its intended roles. The orientation of tax reform, therefore, must conform to the requirements of the development of a market economy, forging a tax system that can really Xu Shanda and Ma Lin 71 help the operation of the economy. Tax administration should also make a point of raising efficiency and reducing administrative cost. (b) The Principle of Equity. Taxation should treat all taxpayers equally in the sense of horizontal and vertical equity. By the former is meant that taxpayers with equal economic ability (ability to pay taxes) must pay the same amount of tax; that is, treat people of similar conditions with similar methods. By the latter is meant that taxpayers with different economic abilities must pay different amounts of tax; that is, treat people of different conditions with different methods. (c) The Principle of Standardization. The nature of taxation calls for standardization of the tax system. At the same time, standardization is an important condition for the enforcement of tax laws and the realization of an equal tax burden. The design of the overall taxation system, the determination of various tax elements and the methods of tax collection and administration, therefore, must all be considered from this starting point. No efforts shall be spared to render the system unified, integrated and scientific, respecting international norms as well as China's specific characteristics. Care must also be taken to avoid as much as possible the usage of policy changes instead of structural changes. These principles must be integrated into tax legislation. (d) The Principle of Functional Finance, also known as the Principle of Stabilizing Economy. Taxation is a lever used by the government to regulate the economy, specifically to maintain full employment and relatively stable prices. When the economy is approaching full employment and is experiencing inflation, the tax rates can be raised so as to alleviate the pressure of inflation; when growth of the economy is slowing down and unemployment rate is rising, the tax rates should be lowered so as to curb the trend of economic recession. (e) The Principle of Neutrality. Under market economy conditions when the average social profit rate is being established, the market will play a leading role in resource allocation. Therefore, taxation should be as neutral as possible; that is, taxation should not interfere or distort the effective operation of market mechanisms. D. MAIN PROBLEMS OF THE EXIsTING TAx SYSTEM China's prevailing tax system leaves much to be desired in terms of these principles for a tax system in the development of a market economy, although outstanding achievements have been reached in reforming the system over the past few years. It is necessary and urgent to further reform China's tax system. The main areas of conflict between China's present tax system and a market economy are as follows: 72 Market Economy and Tax Reform in China (a) Through the gradual evolutionary process of economic structural reform, China has established an enterprise income tax system whereby enterprises of different economic nature belong to different categories of taxes with different tax rates and preferential treatment, resulting in unequal tax burdens that are detrimental to pushing the enterprises to the market and fair competition. (b) High nominal tax rates but low actual tax burden. Take the state-owned enterprise as an example; its nominal tax rate is 55 percent. However, its actual tax burden is far less than this figure because of the practice of repayment of loans before taxes and the management contract responsibility system. The same is true with turnover taxes and other taxes since the tax base is incomplete and there are various kinds of preferential tax treatment. (c) An irregular and convoluted distribution relationship exists between the state and enterprises. The state's functions in distribution are not duly reflected as the manager of society and owner of the state's properties. (d) The scope and depth of regulation by taxation are not in line with the requirements that all productive elements should enter into the market. The regulating functions played by taxation are very weak in such areas as added value of land, individual income and capital market gains. The structure of tax revenue needs appropriate adjustment in accordance with changes in sources of income. (e) A complete local tax system has yet to be established. Revenues raised by local taxes are very limited. The division of tax administrative power is not very rational, which impedes the smooth transition to a system whereby the central government and the local governments raise their own revenue through different taxes. (f) The current turnover tax features too many rates and steep rate brackets. This is because the turnover tax is designed to alleviate the sharp differences in profit margins of enterprises resulting from the controlled price system. Presently, however, most commodity prices have become market-controlled. Given this condition, it is apparent that a neutral indirect tax system should be established in accordance with the requirements of a market mechanism. (g) The fact that domestic enterprises and foreign-funded enterprises are under the jurisdiction of two separate tax legislations causes contradictions that are becoming more and more acute. E. PROPOSED REFORM OF CHINA'S TAX SYSTEM The decision to establish a socialist market economy has brought forth a series of issues to be resolved. It is our view that the guiding ideology for designing the Xu Shanda and Ma Lin 73 tax reform should be as follows: tax laws should be unified; the tax burden should be balanced; the tax system should be simplified; the division of tax jurisdiction should be rationalized; the pattern of allocation should be standardized and allocation relationships should be put in order. The principle of enlarging the tax base, rationalizing the tax burden, reducing tax incentives and enhancing penalties should also be followed. Tax Structure China is a developing country whose productivity level is not high and whose people do not have much income. It lacks the ability to establish a tax system with direct tax as the main revenue source in the foreseeable future. Based on the actual conditions of our country, the design of the tax structure must take account of the dual requirements of state finance and economic regulation. Production and circulation are two stages whereby the national income is created and realized, respectively. Extensive and easy-to-control tax sources are concentrated there. Taxes levied on these stages can guarantee the steady growth of tax revenue and effectively play the function of regulating production, circulation, distribution and consumption. Furthermore, the stage of allocation of national income is mainly the stage of allocation of enterprise net income, i.e., the enterprises' profit. The tax source is thus relatively concentrated. Taxes levied at this stage can also play a certain regulatory function, particularly with regard to allocation. Therefore, starting from the actual conditions of the state, it is appropriate to choose the turnover tax, which taxes the sales of commodities at the production and distribution stages, and the enterprise income tax, which taxes the enterprise's profit at the allocation stage, as the main taxes of the country's tax system. In addition, some supplementary taxes will also be enacted to complement the main taxes so that the function of taxation will exist in all economic sectors. Currently, tax revenue from turnover taxes [value-added tax (VAT), product tax, business tax and the consolidated industrial and commercial tax] exceeds two thirds of total tax revenue (excluding customs duty). Such a large proportion presents some difficulty for the next phase of tax reform. Therefore, short-term tax reform should, first of all, consider adjustment of the revenue structure. Given the particular development level of our national economy and the specific conditions of our economic system, however, turnover tax revenue will continue to make up the better part of total tax revenue for an extended period of time. It is in conformity with our state's specific conditions and it is necessary to maintain the situation in which the turnover tax and the income tax are the main taxes, complemented by other supplementary taxes. Reform of the Enterprise Income Tax The immediate-term target of enterprise income tax reform is to unify the domestic enterprise income tax. The now-separate domestic enterprise income tax and the income tax of enterprises with foreign investment and foreign enterprises will be unified to form an "Enterprise Income Tax Law of the People's Republic of China," applicable to all enterprises. The establishment of a unified and standardized domestic enterprise 74 Market Economy and Tax Reform in China income tax system will not only eliminate an obvious obstacle to the transformation of enterprises' operating mechanisms so as to help push the enterprises to the market and create a fair and competitive environment, but also may set right the allocation relationship between the state and enterprises. The main ideas on unifying the domestic enterprise income tax are as follows: (a) Unify the current State-Owned Enterprise Income Tax, the Collective Enterprise Income Tax and the Private Enterprise Income Tax. Phase out the Adjustment Tax for State-Owned Enterprises. (b) Reduce the income tax rates for enterprises to a uniform 33 percent flat rate. Appropriate measures will be adopted within a certain period of time to take care of small enterprises. Unify and standardize the items deductible and the corresponding limits. In order to avoid erosion of tax base, deductions before taxes must follow the stipulations of the tax law. (c) As a supporting measure to the unification of domestic enterprise income taxes, the present practice of the repayment of loans as tax-deductible items will be changed to the more international practice whereby loans have to be repaid from after-tax income. With the introduction of this system, the key energy and transportation construction funds and the budgetary regulating fund appropriated after taxes should also be eliminated. (d) The state, as owner of state-owned enterprises, has the right to share in after-tax profits of enterprises. Considering the actual conditions of the enterprises, however, most enterprises except a very few will be allowed to keep all their after-tax profits for a certain number of years. Unifying the domestic enterprise income tax is of great significance to the deepening of economic structural reform. It will touch upon a series of reforms in the deep layer of the reform of enterprises' systems, including the depreciation system, the investment system, the financial system, the wages and bonus system and the employees' social security system. Reform of the enterprise income tax system and these reforms constrain each other, influence each and promote each other. With the aforesaid reform measures being gradually put into place, the policy framework for the transformation of operating mechanisms of enterprises will be guaranteed. Changing loan repayment from before taxes to after taxes is a key point in unifying the domestic enterprise income tax. Simply put, loan repayments before taxes are remnants of the system of all profits remitted to the state and all expenditures of the enterprise allocated by the state. The main manifestations are: first, investment loans borrowed by enterprises are mainly guaranteed by the state's tax revenue. Enterprises and banks both take relatively small risks. This kind of no-risk investment mechanism will surely result in an unreasonable investment structure and poor investment return. Second, Xu Shanda and Ma Lin 75 reckless investment causes an overheated investment situation, which is detrimental to macrocontrol of the state. Third, the income tax base of enterprises is seriously eroded, resulting in a great gap between the nominal tax rate and the actual tax paid. This can in no way support the steady growth of the state's financial revenue. With the introduction of repayment of loans after taxes, a risk-taking mechanism will be built into the investment system of enterprises. This is conducive for the enterprises to raise their investment efficiency and improve their economic performance. It is also helpful in the view of enterprises building up within themselves the mechanisms of self-constraint and self- development. This is a crucial link for prodding enterprises to change their operating mechanisms. Without making enterprises responsible for investment risks, it is out of the question to talk about the transformation of enterprises' operating mechanisms. Reform of the Turnover Tax Reform of the turnover tax is targeted at establishing a system whereby the VAT, the product tax and the business tax coexist and a two-tiered regulatory function is formed. Specifically, the VAT will be used in the production and circulation sectors of general commodities, while the product tax will be used for special regulatory purposes applicable to only a few selected consumption goods such as cigarettes, alcohol, gasoline and cars. In addition, a business tax will be imposed on the tertiary industries except commercial wholesale and retail businesses. When China was beginning to introduce the VAT, there was a view that the VAT could be levied at only the manufacturing stage with the purpose of eliminating cascading taxation. However, the experience of trial experimentation of the tax over the past dozen years has shown that what we have done is a superficial introduction of computation methods of the VAT, while overlooking the requirements of a wide base and simple rates that are decided by the nature of the tax. This negligence plus a controlled price system have combined to cause the problems of complicated computation processes and distorted deductions. Future reform will follow common international practice, determine the standardized principle and make the VAT cover all stages of production and distribution of commodities, while at the same time simplifying the tax rates. Only in this way can the function of this tax be brought into play. This is because, first, only when the tax is extended to all stages of production and distribution can the system of deducting the VAT based on the tax stated on the invoice be established. The current practice of deducting tax based on the purchasing cost does not reflect the true tax element and usually results in tax leakage. Thus, a checks-and-balances mechanism among taxpayers themselves will be established. Second, the computation methods will be greatly simplified so that tax compliance and tax administration will both be more convenient. Third, the chronic problems of distinguishing wholesale and retail businesses can be solved; at the same time, by setting the standard rate of the VAT at a higher level, the tax burden at the retail stage will be shifted forward somewhat and benefit can be gained from reducing tax evasion at the retail stage because of poor control. Specific ideas on turnover tax reform are as follows: 76 Market Economy and Tax Reform in China (a) Extend coverage of the VAT. As the first step, the VAT will be imposed on all manufacturing sectors; during the second step, it will be extended to the retail stage. (b) Simplify the tax rates. Tentatively, there will be three to four rates at the beginning. When it is extended to the retail stage, the rates will be further streamlined to one to two rates. (c) The production type of the VAT is considered to be appropriate since allowing the deduction of the tax elements contained in fixed assets purchased by enterprises is an important incentive to encourage enterprises to conduct technological renovation and expand their production scale. (d) Simplify the computation and collection methods of the VAT. The VAT should be levied using the method of deduction at purchase and should be deducted based on the tax stated on invoices. (e) With regard to a few special commodities and some luxury consumption goods, on top of the general regulation by the VAT, a product tax will be imposed to give a second-tier special regulation. Given that the prices of some intermediate products are not rational and the fact that the tax burden of a considerable number of products will be reduced after the rates are merged, to safeguard the state's revenue it is advisable to maintain a large coverage of product tax, i.e., the product tax will be levied not only on some of the final consumption goods, but also on some of the intermediate products. With the growth in financial revenue, the perfection of market mechanisms and reform of the price system, levies on intermediate products will be gradually reduced and finally eliminated until the tax is only imposed on a few final consumption goods. (f) The business tax mainly plays its function in the tertiary industry sector. Its tax rates will be adjusted in accordance with industrial policy and the actual condition of development of the tertiary industry. (g) Domestic and foreign-funded enterprises' turnover taxes will be unified. Reform of the Individual Income Tax Equitable allocation of income is one of the important social targets a socialist country seeks to attain. The market, however, is not able in itself to realize this objective. Therefore, appropriate income and tax policies are devised by the state to maintain the impartiality of allocation. Presently, the three taxes charged the average person, namely the individual income tax, the individual income regulatory tax and the income tax on individual businessmen of cities and towns, exist in parallel. This practice lacks legality, Xu Shanda and Ma Lin 77 standardization of legislation and policy integrity. Thus, it causes some contradictions. With a view to implementing effective macrocontrol by means of taxation in the field of allocation, a new individual income tax system will be established through reform in the near term to: (a) set the allocation pattern of distribution based on work being the main allocation method, supplemented by others; (b) embody the principle of taking into account both the partiality and efficiency that the socialist market must adhere to; and (c) acknowledge reasonable differences in individual income while at the same time protecting against people becoming too rich or too poor. The specific ideas are as follows: (a) A unified "Individual Income Tax Law of the People's Republic of China" is to be formed to consolidate the current individual income tax, individual income regulatory tax and income tax on individual businessmen of cities and towns. (b) In reference to the common international practices, expand the scope of levy of the individual income tax. An individual's income from business operations will be brought under the coverage of this tax. (c) The individual income tax will use progressive tax rates. Experience of foreign countries will be assimilated in connection with the actual conditions of our country when setting up an appropriate level of tax burden. (d) The individual income tax will adopt different allowable deductions with respect to Chinese citizens and foreigners. Reform of Local Taxes With the furtherance of economic structural reform, the shortcomings of the current contracted financial system started to surface. The relationship between the central government and local governments needs urgent adjustment. The direction of reform is to implement a separate tax jurisdiction system. Tax reform must suit the implementation of this system. (a) Establish a local tax system. Those taxes that have less significant macroregulatory functions but are closely linked with development of the local economy and also are convenient for local governments to administer will be assigned to local governments as their fixed revenue. Tentatively, in addition to the present local taxes, the business tax will basically fall within the jurisdiction of local governments. Second, the scope of levy of the resource tax will be extended and its revenue will belong to local governments. Third, taxes levied on property and land will be local taxes. (b) Expand the scale of local tax revenue. Raise considerably the proportion of local tax revenue in relation to total tax revenue so that local governments can cover most of their expenditures by raising their own money. 78 Marke Economy and Tax Reform in China (c) On the premise of concentrating necessary macrocontrol power, set right the relationship of centralization and decentralization with respect to tax administration. The present chaotic situation of tax administration must be changed. Jurisdiction powers over taxes that have been assigned as fixed local government revenue should be mostly delegated to the local governments. (d) The tax legislation power of local taxes can be delegated to the legislative organs of the provinces, autonomous regions and the municipalities directly under the State Council, except those that require unified implementation across the country. (e) Reform and perfect local taxes to optimize the tax structure. Presently, our country has formed a framework of a compound tax system; only the choices of taxes are not very reasonable. To take local taxes as an example, some should be merged or abolished, some should be restructured and perfected, and a few new taxes will be enacted. Specifically, the market trade tax and the banquet tax will be abolished; the livestock trade tax and the slaughter tax will be merged to relevant taxes; the city house and land tax and the vehicle and vessel license tax will be replaced by a unified real estate tax and vehicle and vessel use tax. Studies will be carried out to enact a real estate transaction tax (tax on added land value), security transaction tax, inheritance tax, gift tax, and social security charge. F. MEASURES SUPPORTING REFORM OF THE TAx SYSTEM Reform of the Tax Administration System. The current tax administration system of China was formulated in 1977. Constrained by the then planned economy management structure, this system focused on the division of administrative powers. Since then, China's tax system has undergone significant adjustment and reform. Furthermore, great changes have also taken place in the state's economic structure and economic situation. Under such conditions the fact that the current tax administration system falls far short of reform of the economic structure and the tax situation is becoming more and more acute. Therefore, corresponding reform should also be initiated in the current tax administration system. The general principle will be to divide tax administrative powers in accordance with tax revenue. Central government revenue will be administered by the central government; local revenues will be under the jurisdiction of local governments; shared revenue will be administered at different levels according to where they are remitted to the treasury. Tax Legislation Work. Presently, of all the tax legislation in our country only the following are promulgated by the National People's Congress and enjoy the status of law: "Income Tax Law for Enterprises with Foreign Investment and Foreign Enterprises," "Individual Income Tax Law" and the procedural law "Tax Collection and Administration Law." Most other taxes have not yet been legislated. Some have only the status of provisional rules, of which some do not even have implementation regulations; Xu Shanda and Ma Lin 79 still others have been implemented in the form of draft regulations for quite a few years. To establish a modern market economy, it is not only necessary that legislative work be carried out in parallel to tax reform, but also that tax legislation must become a guarantee of tax reform. Therefore, tax legislative work must be strengthened. At every step of tax reform, laws must also be implemented in accordance with legal procedures to realize the target of placing taxation on a legal and standard basis in a market economy environment. Reinforcing Tax Administration. The establishment of a tax system that suits the needs of a market economy must be supported by powerful tax administration. Strengthening of tax administration should adhere to the principle of rule by law and strict enforcement. Key efforts should be made to locate and prosecute tax evasion and leakage cases. Severe punishment should be administered on those who resist paying taxes through violent means. The principle of severe punishment should also be reflected to enhance the deterrent effect of tax law. Through strict enforcement, market transaction activities can be disciplined and the market order straightened; all abnormal competition and actions in violation of the market order will be checked so that the tax laws and tax policies can be smoothly implemented. Striving to set right the allocation relationship of tax revenue and perfect the tax system in the next few years is of great significance to the development of a market economy. Tax reform, being a major element of the macroeconomic policy, is a complicated systems engineering project. It entails a series of reallocations and readjustments of economic benefit to various sectors. Therefore, it is necessary to have strong leadership as well as the support of the reform of the macrocontrol system. In designing the reform, extensive investigation must be carried out, meticulous forecasting and verification must be conducted, opinions of different departments and economic sectors will be solicited and international experiences will be conscientiously studied and assimilated. Through these reforms, the tax system of our country will be more streamlined and rational in structure and more efficient in function. Nicholas Stern and Athar Hussain on Xu Shanda and Ma Lin 81 COMMENTS ON "MARKET ECONOMY AND TAX REFORM IN CHINA" by XU SHANDA AND MA LIN Nicholas Stem and Athar Hussain 1/ A. INTRODUCTION The paper raises a number of interesting issues, which we discuss under the following headings: (a) general problems of government revenue and expenditure; (b) specific issues of tax reform arising from the shift toward a market economy; (c) the division of revenue and expenditure between the central, provincial and lower government tiers; and (d) the possibilities of raising the ratio of taxes to national income. B. GENERAL PROBLEMS To highlight the main issues at the aggregate level we start with two paradoxical observations. (a) Observation 1. The ratio of government revenue to national income has since 1978 fallen steadily. In 1992, while national income grew by 12.8 percent, government revenue rose by only 9 percent, which makes the elasticity of tax revenue with respect to GNP equal to only 0.7. (b) Observation 2. Yet in terms of the ratio of deficit to national income or a neglect of the infrastructure and the public services, China does not show the usual symptoms of a serious public finance problem. The ratio of deficit to national income (as officially measured) is between 2 to 3 percent, which is low for an economy with an average growth rate of around 9 percent per year. This paradox may be explained in two ways: the underestimation of the budget deficit, and, second, the growth of "off-budget" revenues and expenditures of various government tiers. The implication is that the paradox is only apparent and due to a measurement error. The government budget, as presently compiled in China, underestimates both expenditure 1/ Nicholas Sterm is Chief Economist of the European Bank for Reconstruction and Development and Athar Hussain is Associate Professor, London School of Economics. 82 Comment and revenue, and the extent of underestimation would seem to be greater for expenditure than for revenue. The fall in the ratio of government expenditure and of revenue to GNP over the reform period is therefore not as great as suggested by the official figures. Nevertheless, there is an increasingly serious public finance problem for two reasons. First, the government budget is a central tool of macroeconomic policy in a market economy and, to serve this purpose effectively, it should accurately reflect the government claim on resources, which in the present-day Chinese economy it does not and thereby weakens the role of fiscal policy in macroeconomic regulation. Second, as we explain below, the two factors that explain away the paradox, the underestimation of the budget deficit and the growth of off-budgetary accounts, are a source of problems that should of serious concern to the Chinese government. Turning to how the budget deficit is underestimated and the problems it creates, the government, in addition to borrowing on its own account by selling bonds, also instructs commercial banks to lend for particular purposes (the so-called policy lending), much of which may not be justified on commercial grounds. More serious, such "forced" lending is not a new phenomenon but has been widespread since the mid-1980s when central banking was separated from commercial banking. As a result, there has been a steady accumulation of nonperforming loans in the portfolio of banks, which according to some estimates may be as high as 40 percent of the outstanding loans. As would be usual in developed market economies, these loans are not written off (partially or wholly) in the Chinese economy, and the balance sheet of banks is not annually reevaluated. The large stock of nonperforming loans poses a problem both for the stability of the banking system and for the public finances. For the banking system, because it means that the "actual" assets of commercial banks are substantially lower than claimed in their accounts, and they may not be enough to cover their liabilities, which are the deposits of households and enterprises. An assessment of the balance sheet in line with the usual banking practice in developed market economies may reveal some of the Chinese commercial banks to be financially insolvent. The nonperforming loans pose a problem for the public finances because the government will in future have to do something about them as part of the financial sector reforms, such as exchanging them for government securities, as happened in the Republic of Korea and Taiwan (China) in the past. The implication is that these loans are a potential financial liability for the government and should be included in its debt. Turning to the off-budget revenue and expenditure of central and provincial governments, they have grown rapidly since the early 1980s. To give an idea of the magnitude, in 1990, the off-budget revenue was equal to around 75 percent of the in-budget revenue and 70 percent of the in-budget expenditure. The off-budget revenues take a variety of forms, including levies and contributions for particular purposes, and income from "companies" owned and run by the government, and they raise a number of serious issues. First, they undermine the effectiveness of budgetary policy for macroeconomic regulation because they provide central government agencies and the provincial and lower governments the possibility of avoiding, for example, control on expenditure, by transferring expenditure to the off-budgetary account. Second, off-budget revenues, much of which are from taxes except in name, are outside the tax law and go Nicholas Stern and Athar Hussain on Xu Shanda and Ma Lin 83 against the precept of good taxation that taxes should be transparent rather than concealed. Third, off-budget levies and forced contributions undermine the "legal" tax system because they reduce the incentives on the part of provincial and lower government tiers to collect the legally prescribed taxes. The reason is that, unlike with taxes, they do not have to share off-budget levies and contributions with the central government. Fourth, they have become an increasing source of social dissatisfaction, as evidenced by recent reports of discontent in rural areas against their proliferation. From the above discussion, we would draw two general conclusions about a reform of the public finances. First, a central component of such a reform should be an overhaul of the government accounts with a view to bringing under control the growth of off-budget revenue and expenditure and eventually instituting a system of comprehensive budgetary accounts encompassing all government expenditure and revenue. Second, tax reform should also cover off-budget levies and make them subject to laws and regulations exactly in the same way as taxes. The drive to improve tax collection should go together with a drive to eliminate arbitrary levies and charges by government agencies. C. SPECIFIC ISSUES OF TAX REFORM Before dealing with particular taxes, we consider first the features that distinguish the present-day from the prereform Chinese economy and that are central to a discussion of tax reform. (a) There is now a large number of nonstate-owned enterprises of various types and they account for around 50 percent of industrial output. It is easy for state-owned enterprises to establish subsidiary collective enterprises and joint ventures. Enterprises can now finance investment through a variety of sources, including own funds, bank loans, bonds and also increasingly stocks or shares. (b) With the development of a market economy, there are ample economic incentives and possibilities for enterprises and individuals to "avoid" and "evade" taxes. The government (tax authorities) has less reliable information on enterprise profits and individual incomes than in the past because market-oriented accounting and independent auditing are still in their initial stages of development. (c) Decisions about production and investment are increasingly made by enterprises and households on the basis of economic considerations, and these are crucially affected by taxes and the government pricing policy. It is therefore increasingly important for the government to take account of the effects of its tax policy on incentives and economic efficiency. (d) As documented by Mr. Li Yuan in his paper on "Distribution System Reform in the Transition to a Market Economy, " there has since 1978 been a significant increase in the share of national income going to households. 84 Comment Direct government control over the distribution of income among individuals is much weaker than before; and there is some evidence that inequality has increased, though it still remains considerably lower than in most economies. (e) Since 1978, there has been a considerable decentralization of government. Provincial and lower government tiers are playing an increasingly important role in economic decision-making and the design of economic reforms. The features listed above amount to a fundamental transformation in the structure of the economy and call for a radical overhaul of the tax system rather than just a marginal reform. Broadly, the first three concern the enterprise taxation and the turnover taxes. The fourth has implications for the share of the personal income tax in total tax revenue, and the weight to be given to distributional objectives in determining the rate structure of the personal income tax and the turnover taxes. The fifth concerns the respective tax revenues and the expenditure responsibilities of the central and lower government tiers. We now go on to consider particular taxes mentioned in the paper. Enterprise Profits Tax The paper makes a strong and a convincing case in favor of a uniform tax schedule for all types of enterprises and the abolition of various tax deductions, especially of the loan principal. It may be argued that the higher tax rate for state-owned enterprises is increasingly counterproductive as it provides them with an incentive to avoid the higher tax rate by establishing collective enterprises and real or "phantom" joint ventures. The government has already decided in favor of a standard tax rate of 33 percent for all types of enterprises, which will lower the nominal tax rate for large- and medium-size state- owned enterprises. It has also decided to abolish the deduction of the loan principal from the tax base, which, we would point out, is equivalent to writing off a percentage of enterprise debt, determined by the marginal tax rate faced by the enterprise. There would seem to be a strong argument to implement the abolition of the deduction of the loan principal simultaneously with the reduction in the tax rate rather than after. The abolition of the deduction may pose special problems for some state-owned enterprises, but it would seem better to deal with the problem directly through a one-off financial restructuring by writing off a proportion of the loans of such enterprises. There are two serious disadvantages with using the tax system for writing off enterprise debt. First, the extent of write-off is not transparent and is not targeted to enterprises that are in need of financial restructuring. Second, it encourages enterprises to borrow more, thereby increasing the extent of debt write-off that may be needed. We turn now to the problem raised by the underdeveloped state of accounting and auditing, and the lack of reliable information on enterprise profit and incomes of small businesses. Broadly, there are two approaches to deal with the problem. The first consists in getting enterprises to reveal true information through penalties and incentives, on the one hand, and using "outside" information to estimate their taxable profits-the so-called presumptive taxation. In addition to penalties to deter the Nicholas Stern and Athar Hussain on Xu Shanda and Ma Lin 85 falsification of profits and incomes, as suggested in the paper, it would also be important to consider rewards for enterprises revealing true profits. This could take the simple form of having a lower tax rate for enterprises and small businesses adopting the specified accounting and auditing practices. This has been suggested for a number of economies, and it deserves serious consideration in China, as in the long run this would benefit both tax collection and also help develop a more efficient tax system. Turning to "presumptive taxation," we would emphasize that it should be distinguished from penal taxation, and the methods for estimating profits or incomes should be carefully chosen. The "presumed base" should be correlated with the "actual tax base" and, ideally, less open to distortion. Statistical surveys of profits and incomes have an important role to play in presumptive taxation. For example, they are widely used in France for the taxation of small businesses. The alternative approach to the problem of tax evasion is to redesign the tax itself and chose a more easily observable base for enterprise taxation than profits. One such alternative tax base, which has been extensively discussed in developed market economies, is cash flow, which aside from facilitating collection also offers a number of other advantages. Finally, it would be important for China to avoid the anomalous features of corporate taxation in developed market economies. The principal one of these is the different treatment of interest on loans and dividends on shares in corporate taxation. Interest on loans are generally tax deductible but dividend payments are not, favoring the loan financing of investment for which there is no sound economic justification. There are strong arguments for treating them alike for tax purposes. At the present stage in China, the main option would be to allow neither to be deducted from the tax base. As the stock market develops and the individual ownership of stocks rises, there will arise the problem of how to tax dividends distributed to individuals, which is an important issue in developed market economies but not as yet in China. A reform of corporate taxation on the lines suggested in the paper and our comments is unlikely to significantly increase the ratio of corporate taxes to national income. The implication is that the main purpose of a reform of enterprises taxation would be to improve its effects on efficiency rather than to raise more revenue. One would have to look to other taxes if an aim of the reform is to raise the ratio of tax revenue to national income. Turnover Taxes The paper outlines the complex structure of the existing turnover taxes and recommends an extension of VAT to a wider range of commodities and to all stages from production to retail sale. This is in line with tax reforms in a number of countries and fits in with one of the main principles of good taxation. That is, intermediate goods and services should not be taxed, save where output cannot be taxed directly or where there is some special objective, as in the case of a tax on energy that we discuss later. While VAT has many advantages, it does impose a heavy administrative burden on small businesses. As in a number of other countries, it would seem desirable to exempt small 86 Comment businesses from VAT, whereby they do not charge VAT on their sales, but, in turn, they are also not entitled to a refund on their purchases. Complementing VAT with a special "product tax" (or excise taxes) on selected commodities, as suggested by the paper, is also in keeping with the usual international practice. But it is important to emphasize that the commodities subject to such a tax should be few in numbers and capable of yielding significant tax revenue. The paper also mentions that the product tax on some intermediate products may be needed while their prices remain lower than comparable international prices. This may be justified, but it is important to keep in mind the general rule that wherever possible it is better to tackle the distortion at the source by freeing the prices rather by imposing a corrective tax, especially since it can be very difficult to estimate the right level for such a tax. We turn now to the question of the weight to be given to distributional considerations in the setting of turnover taxes. Since at present only a small proportion of individuals pay the personal income tax, there would seem to be a strong argument for a differentiation of rates on distributional grounds. Under VAT this could be done by having different rates, or by exempting certain items from VAT, such as food and child clothing as in the United Kingdom, for example. Here, there is a crucial trade-off between distributional considerations and administrative costs. While the former may require a large number of rates, the latter calls for a few. The usual compromise is to divide commodities into broad groups and tax necessities at lower rate than luxuries. We take up next the issue of the use of turnover taxes to deal with a major aspect of "the negative effects of the market economy," as termed by the paper. There would seem to be a good case for taxes on commodities that have significant negative "externalities," i.e., adverse effects that are not fully taken into account in prices. Coal is one such commodity. A number of countries are either planning or have already implemented an energy or a carbon tax. Although consumption of energy per head in China is low, it is growing rapidly, and the adverse environmental effects of heavy reliance on coal are already apparent in Chinese cities. Coal prices in China have traditionally been low, though they are in the process of being raised to the international level. Rather than leaving it for the distant future, it would be important for China to consider the introduction of an energy tax or a carbon tax in the near future, which unlike VAT will not be refundable. Such a tax offers a number of significant advantages: first, it is likely to be a large revenue source; second, it will encourage efficiency in the use of energy in line with the international trend; and, third, it will help China to meet its international obligations as a signatory to the charter on the global environment. A first step toward such a tax will be to bring energy under VAT. Household energy consumption is rising rapidly in China; a VAT on energy will provide both an incentive to economize and also yield revenue, which is likely to increase faster than household incomes. We turn finally to an issue not mentioned in the paper, the pricing of public utilities, such as transport, urban services and energy. This deserves special attention because public utility prices have traditionally been low or zero in China. In recent years the government has responded to the demand pressure on infrastructure by raising public utility prices or introducing a special tax, as in the case of electricity, in order to finance Nicholas Stern and Athar Hussain on Xu Shanda and Ma Lin 87 investment. Although there is ample justification for raising public utility prices, much of the price increase would seem to be ad hoc, independently decided by various tiers of government and government agencies and not subject to any rule or regulation. In fact, much of the rise in the off-budget revenue would seem to be due to a rise in charges for public utilities, such as electricity, roads, airports, gas and water. This seem to have become a major source of social discontent as it is perceived to be unjustified and arbitrary. The principle we would like to emphasize is that public utility prices should be treated like commodity taxes and fixed according to the principles of good taxation. That is, the price should be equal to the long-run social marginal cost when used as an intermediate good, but carry an element of indirect taxation when used as a final good. It is important to emphasize that this element of indirect taxation should be determined on the basis of the same considerations applying to indirect taxes on commodities rather than separately for each service. A simple way of doing this would be to add VAT to the long- run social marginal cost, save where there are distributional or other social reasons for exemption. Unlike with corporate taxation, there would seem to be possibilities for raising the yield from the turnover taxes relative to national income significantly, especially if an energy or a carbon tax is introduced. Personal Taxation The paper argues for an extension of the personal income tax to a larger percentage of the population and for a progressive tax schedule. Given the significant rise in the share of national income going to households, increasing the yield from personal income taxes relative to national income would seem to be one of the main options for raising the ratio of tax revenue to national income. The share of the personal income tax in total tax revenue is at present very low, and we would argue that the fact that China is a low-income economy should not be taken as a sufficient argument for not extending the range of personal income tax. The main problem for personal income taxation in China is that a substantial part of income accrues in a noncash form, such as heavily subsidized housing provided by work units as in urban areas, and nonmarketed goods in rural areas. We would strongly argue that the base for the personal income tax should include both cash and noncash income. It would be far more equitable and also more productive in terms of revenue to tax all types of income beyond a tax-free allowance at a low flat rate than to tax just the cash income at an increasing marginal rate. The latter could be counterproductive, providing an incentive to work units to substitute noncash income for cash income, which goes against the spirit of market-oriented reforms. When reforming the personal ipcome tax, it would be highly instructive for China to draw lessons from the trend in personal income taxation in developed market economies, such as the United Kingdom, toward only a few rates and a comparatively low top marginal tax rate, but with a wider tax base that also covers the imputed value of noncash benefits. 88 Comment Finally, as China is in the process of reforming the social security system, we would like to draw attention to the relation between social security contributions and the personal income tax. In China at present, labor insurance contributions, which are mostly paid by employers, are not included under taxes. These are taxes like any other except that they are earmarked for a particular purpose. They should be counted under direct personal taxes according to the usual international practice, and also collected by the same authority that is responsible for collecting enterprise and personal taxes. Moreover, from an administrative point it would be efficient to use the same base for social security contributions and personal income tax, as one set of tax returns can be used to calculate both. D. CENTRAL-LOCAL FISCAL RELATIONS In China, tax sharing between the central and provincial, municipal and lower government tiers is based on bilateral contracts. Except in a few cases, tax bases are not assigned to particular government tiers, and there is as yet no general framework for revenue sharing between the central and lower government tiers. The tax revenue contracts are a source of worsening problems. They are often seen as inequitable in that many provinces or municipalities believe that they are paying more to the central government than they should. Moreover, these contracts also seem to provide an incentive to lower government tiers to relax tax collection and instead raise revenue through off- budget levies and charges, which are not shared. Moreover, there is now a large mismatch between the revenue and the expenditure side. The share of tax revenue accruing to the central government has fallen steadily but its expenditure responsibilities have not decreased commensurately. The paper argues for the establishment of a "local tax system" by assigning the business tax (paid by the tertiary sector), and an expanded resource tax and the property and land taxes to lower government tiers. Here we would like to put the simple point that the tax side and the expenditure side should be planned together rather than in isolation from each other. In fact, a discussion of fiscal relations between the central and lower government tiers usually begins with a division of expenditure responsibilities that then provides the basis for an analysis of the division of revenue. The rapid growth of the off-budget revenues and expenditures raises an important general problem for center-local fiscal relations. First of all, it implies that an increasing part of revenue and expenditure by government tiers is outside the framework regulating center-local fiscal relations. The implication is that there is little point in concentrating on a reform of these relations while neglecting the off-budget accounts. Second, although the power to decide on tax rates is divided between government tiers, provincial and lower government tiers are increasingly able to circumvent any limitation on their power to tax by the central government by simply levying off-budget charges. The problem is particularly serious in rural areas where the number of charges have multiplied in recent years. According to a report compiled by the Research Center for Rural Economy of the Ministry of Agriculture, there are as many as 35 different kinds of levies in rural areas in addition to the agricultural tax. The point we would like to emphasize is that an assignment of taxes to subnational government tiers should go together with more strict control than at present on their power to levy off-budget levies. Nicholas Stern and Athar Hussain on Xu Shanda and Ma Lin 89 E. RAISING THE TAX REVENUE TO NATIONAL INCOME RATIO We would like to conclude with some remarks on the possibilities of raising the ratio of revenue to national income, which we take to be one of the main aims of tax reform in China. The main candidates for raising the ratio would seem to be the following: (a) the personal income tax, including social security contributions, (b) the turnover taxes, including VAT, the special product tax (excise taxes), public utility prices and energy or carbon tax; and (c) the property tax, including the tax on agricultural land and the resources tax. We have left out the enterprise profits tax for the reasons mentioned earlier, and also the foreign trade taxes because increasing them is neither desirable from the point of view of economic efficiency nor politically feasible in view of China's impending application to rejoin GATT. The property tax, which is highly desirable from an economic point of view, offers possibilities for raising the ratio, but a significant rise in the ratio of taxes to GNP will also depend on a higher contribution from both commodity taxes and the personal income tax. Given that the commodity taxes already raise a large proportion of tax revenue, the development of a broad-based tax system in China will require a rise in the share of the personal income tax in total revenue. Li Yuan 91 DISTRIBUTION SYSTEM REFORM IN THE TRANSITION TO A MARKET ECONOMY Li Yuan 1/ A. INTRODUCTION The objective of the reform of China's economic system is to establish a socialist market economy. Remodeling of the distribution system is a necessary part of this transition to a market economy. B. CHANGES IN BASIC DiSrRIBUTION POUCIES The most important aspect of this reform entails changing basic income distribution policies from the egalitarian policy known as "eating from the same big pot" to one of allowing some citizens to attain affluence before others. The original distribution policy, which suited the planned economy, aimed at realizing the social ideal of approximate income equality through government planning for the distribution of national income. Practice has proved that this method can help achieve the goal of approximate income parity, but it does so at the expense of efficiency. The new distribution policy is more in conformity with the orientation of a market economy and focuses on influencing and promoting the sustained advance of the entire national economy, so that all Chinese of every nationality can soon become prosperous. In the initial phase of distribution, this objective will be achieved through market valuation and market competition. Experience has established that this change embodies giving priority to efficiency. Improvements in economic efficiency enable the state and society to fulfill, in practice, their demand for equity in the second round of distribution and gradually realize their ideals for common prosperity. C. CHANGES IN THE DISTRIBUnON STRucTuRE, SYSTEM AND CONCRETE POLICIES In accordance with the basic distribution policy of allowing some citizens to become well-off before others, China's distribution structure, distribution system and concrete policies have experienced the following changes: (a) Distribution Structure. The single distribution structure with the government as the main body is changing into a distribution system of multiple entities including enterprises and individuals. The share of national income under direct government control has dropped and the proportion of 1/ Li Yuan is director of the Distribution System Department of the State Commission for Restructuring the Economic System. 92 Distribution System Reform in the Transition to a Market Economy the income of enterprises and individuals has increased. This has occurred as a result of planning system reform, the development of multiple economic sectors, state tax reductions and profit concessions to state-owned enterprises, multiple forms of the contract responsibility system, preferential tax treatment for nonpublicly owned enterprises and a reduction of the burden on farmers. On a final income basis, in 1978 the state held 32.1 percent, enterprises 17.9 percent and individuals 50 percent of GDP: comparable figures in 1990 were 14.6, 21.7 and 63.7 percent, respectively. (b) The Distribution System. The centralized, planned and direct income distribution system is changing into a pattern of market valuation and market competition. Before the introduction of reform and opening up, only a small number of farmers and individual city-dwellers participated in social distribution through selling their own products or providing labor services. Moreover, most prices for their goods and labor services were subject to planned direct control. Following the implementation of reform and the open policy, not only farm and sideline products of farmers and their labor entered the market, but also in farmer-run township enterprises and urban and rural nonpublicly owned economies, incomes were regulated and distributed mainly through the market. The linking of total wages to enterprise economic returns for the income of workers in state-owned enterprises also introduced market factors. Some scientific research, culture, education and medical institutions have become more market- oriented, with their own earnings in addition to state-provided funds. Citizens have diverse sources of income, with some obtaining quite large earnings directly through the market. The proportion of urban residents' income gained from their own work units dropped from 91.2 percent of total income in 1981 to 73.8 percent in 1991, with the balance being income from self-employment. (c) Concrete Distribution Policies. The principle of income distribution according to work has now been truly established, supplemented by other distribution methods. The introduction of the system whereby labor results are assessed and incomes apportioned through the market is better designed for implementing this principle. While work remains the main factor, other additional production factors also include prices and profits, which the state recognizes as necessary supplements. These include interest, profit sharing, dividends, risk compensation and casual labor incomes. These are permitted within legal limits. How can people who are accustomed to the old distribution structure and system become accustomed to the new distribution system and how can reform prevent distribution reform from undermining social stability and security? This affects the success of the reform of China's economic system and relates to whether market economy objectives can be adhered to and not be rocked. Li Yuan 93 D. THE QUESTION OF DIsTuIBUTrION PATTERN Change in the distribution structure will inevitably entail changes in the distribution pattern. One view holds that currently the share of personal income is too large, which means income distribution is overly tilted toward individual persons. Exponents of this view propose increasing the proportion of government financial revenue. In fact, the question does not lie in the increased share of personal income. (a) Increases in the proportion of earnings of enterprises and individuals coincide with progress in reform of the entire economic system, with income increases for individuals inevitable and necessary; (b) The new pattern has become relatively stable in recent years, and enterprise income, in particular, has increased somewhat. Figures are given in Table 1. Table 1: PROPORTION OF INCOME DISTRIUTION (Percent) 1978 1984 1985 1988 1989 1990 State income 32.1 21.1 21.7 15.1 15.0 14.6 Collective 17.9 19.4 17.3 20.7 21.1 21.7 Individual 50.0 59.5 61.0 64.2 63.9 63.7 Urban 22.1 22.9 23.8 27.2 28.0 29.2 Rural 27.8 36.6 37.2 37.0 35.9 34.5 (c) Pattern changes have not adversely affected accumulation rates. Increases in enterprise and individual incomes have not resulted in inappropriate growth of consumption. On the contrary, the accumulation rate remains high. Between 1984 and 1991, the accumulation rate hovered around 31.5-35 percent, with changes only in the main source of investment finance. There is no denying that certain phenomena coincided with changes in personal income distribution patterns. One was growth in citizens' wealth. Savings deposits and other financial assets of urban and rural residents reached Y 1,352 billion by late 1991. Another was the increase in government budget deficits. Although proposals for increasing the state's share in financial distribution were offered many years ago, we are now confronted with demands for tax reduction and profit concessions by state-owned enterprises, the main source of state financial income. We also face complaints by employees of state-owned enterprises about their relative decline in income. The solution to the problem can only lie in further readjustment of the scope and structure of 94 Distribution System Reform in the Transition to a Market Economy government expenditures plus enhancement of expenditure efficiency, and simultaneous active development of the capital market and encouragement of investment by enterprises and individuals. Serious problems lie in the following: (a) Due to multiple forms and diversification of economic activities, the problem of lack of economies of scale in production has become ever larger, huge amounts of state tax revenues have been lost, and the market economy has presented new problems for state management. (b) State-owned enterprises have suffered losses over a wide area and of large amounts, constituting a widely known problem. In addition, there are no rigorous mechanisms for controlling distribution. Over the dozen years of reform efforts, the products of state-owned enterprises have begun to enter the market, but basic production factors-assets and labor-have not joined it. Assets not only are unable to flow rationally, but receive no market appraisal. It is possible to play with false profits that are actual losses, and bargain with government departments when below-target or zero production happens. Nevertheless, the number of personnel and size of wage and welfare bills cannot be reduced, but tend rather to increase. The basic contracting figures of some enterprises are comparatively low, while wages and welfare, which are free from market supply restrictions on labor forces, are especially liberal. Some state-owned enterprises have even declared they will take the lead in raising per-capita wages to the level of comfortable lifestyles for employees. In contrast, township enterprises, private enterprises and foreign-funded enterprises do not issue bonuses and increase wages indiscriminately, since they are restrained by the market. Therefore, steering of enterprises to the market should include pushing their distribution toward market determination. At present, 40 percent of state-owned enterprises still engage in wage planning for an absolute increase amount as allocated by the state; 55 percent link pay with performance; and a few exercise control over the two rates (economic efficiency growth and labor productivity). Generally, it is planning and negotiation mechanisms that play the leading role. (c) The relative decline in the income status of employees in state-owned enterprises, institutions and organizations and the sustained egalitarianism in their income distribution have resulted in irregular compensation practices. This has obstructed the establishment of a normal market order and incurred serious losses for the state. The orientation for policy adoption should be to increase the allocative role of the market and establish a tax collection and management system suited to a market economy. Reform measures should be as follows: Li Yuan 95 (a) We should establish uniform standards for the determination of enterprise wages, bonuses and welfare funds, and count all costs of employment. Auditing and tax collection should be conducted by the state on legal lines. We should not continue to use the method of setting total wage estimates by planning methods. (b) Reform of the wage system must be coordinated with reform of the labor system. Enterprises are to be allowed to hire labor independently. They should form a mechanism whereby the basic wage level is determined by the market. Enterprises free from management restriction should gradually introduce liberal distribution. The bonus tax paid by enterprises should be abolished and personal cash income should be encouraged to increase transparently. Personal income should be regulated by the levy of a personal income tax. (c) The wage level of enterprises not under independent management should be determined in light of the market level rather than through negotiation on a one-to-one basis. The current irrational phenomenon under which the greater losses enterprises suffer, the higher the wages paid to their employees, should be changed. (d) The pace of wage reform should be quickened in government organizations and institutions. Institutions should be operated, as far as possible, as enterprises. Government organizations should be streamlined as far as possible; their wage level should be set in reference to levels in enterprises. (e) Publicly owned enterprises should introduce market appraisal mechanisms for income distribution. Apart from setting up different wage systems for enterprises, institutions and government organizations in accordance with their different characteristics, we should form a mechanism whereby jobs are obtained on a competitive basis and income is received in accordance with an individual's contribution. Incomes set for different enterprise personnel should be varied to suit market patterns. A piece-rate wage should be introduced as far as possible, where applicable. Remuneration for suppliers and sales people should be linked as far as possible with their supply and marketing contributions. Research results achieved by scientists and technicians should be used and adequately compensated as far as possible. (f) Manager conduct should be restrained by owners. Managers' incomes should not be linked with that of ordinary enterprise workers and staff, but rather with the maintenance and increase of asset values. Rewards to contractors for profits earned within a specified time limit will be mainly in the form of certificates (such as shares) through which they can enjoy future profits of firms. Their short-term actions should be restricted and guided by future market appraisal of enterprises and the associated long-term benefits. 96 Distribution System Reform in the Transition to a Market Economy (g) We should study and draw on the methods and expertise used by capitalist countries in coping with underground economies to improve the collection and management of taxation. Common management methods should exist for some laws governing economic behavior that are common under market conditions. Therefore, we should employ successful capitalist experience in market management. For example, the use of "external form tax collection" (that is, for enterprises whose accounts are difficult to verify, the basic figure for tax collection is determined on the basis of their external production and management conditions), and reduction of tax rates to expand the tax base. (h) We should set up accountant offices that play the role of "economic police" in society, audit enterprise books, and take them as the basis for declaration of taxable income. With regard to enterprises unable to set up accounts and systems, accountant offices designated by the government can act on their behalf. (i) Some work units and special personnel can be chosen selectively to initially implement this personal income tax. For example, enterprises and institutions engaged in independent distribution can declare for individuals, famous actors and actresses, self-employed business people. Large private businesses can be first designated to implement such systems. E. QUESTION OF FAIR DISTRIBUTION The issue in relation to income gap is fair distribution. Parity, by and large, exists in income distribution in Chinese society. The Gini coefficient, which reflects the income gap of urban residents, was 0.16 in 1978 and it rose to 0.23 in 1990 (the figure is 0.3-0.4 in most developed countries, and 0.4-0.6 in most underdeveloped countries). This limited widening of the income gap has aroused widespread concern. In the initial period of reform and opening up, people did not understand the emergence of an income gap, thinking that a widening gap meant "unfair distribution." There is less such concern now. Discussion focuses on egalitarianism, which is considered to constitute unfair distribution. There is now more mention of unequal opportunities and complaints about declines in personal income status. The reasons are as follows. First, differences exist between the planned and market systems. People usually mention several kinds of high-income earners in this regard. They include individual industrial and commercial businesses, proprietors of private enterprises, famous stars, moonlighters, employees at foreign-funded firms, taxi drivers and contract managers. They are the ones who entered the market system first. Their incomes encompass market risk. An oversimplified comparison is impossible between them and employees in state- owned enterprises and institutions since personal responsibility for consumer and social security expenses are so disparate between the two groups. According to a survey conducted by the All-China Federation of Trade Unions, in 1990, per-capita income of the nation's workers and staff (including wages and welfare) was Y 4,048.2. A survey Li Yuan 97 conducted by the Beijing Tourism Bureau shows that per-capita annual wages and welfare benefits of employees of state-owned units stand at Y 8,000. Second, friction exists between the new and old systems and improvement of the latter requires a fairly long process. In the initial stage of market economy development, many market regulations have yet to be set up. It is true that a small number of people have the chance to easily and quickly become rich. Even once the market economy has become relatively developed, many nonmarket factors will still apply in the area of income distribution. It is only natural that citizens are concerned about whether the opportunities, means and channels for obtaining incomes are equal and rational, that is, whether income mechanisms are equitable and just. This fair distribution referred to includes the three different concepts of equalization, equality and justice. The focus of equalization is on differences in result and amounts. In primary distribution, there is no absolute equality to speak of. Equal social income and narrowing of income gaps can be achieved only through redistribution. Achievement of this requires highly developed productive forces, social wealth on a large scale and consensus for increased central control of national income for purposes of redistribution. Premature attempts to accomplish this can only hinder economic development. Equality refers mainly to conditions and opportunities for participation in the distribution of wealth. Equality is an historical concept. Under socialism, equality is only relative. Each person's natural gifts, ability, educational level, initial wealth, residence and surrounding environment cannot be uniform. Enterprises in the same field may have completely different internal and external conditions. Justice refers mainly to regulations on the process of distribution. Everyone should abide by the same standards and carry out legitimate competition. A society can tolerate imbalance and inequality, but it cannot tolerate injustice. Orientation for New Policies. We should attach particular importance to safeguarding social justice and, in the process of setting up a market economic system, pay attention to the construction of market standards and regulations for competition. In income distribution, we should gradually standardize the income formation mechanism, promote and protect fair market competition, try as far as possible to reduce artificial monopoly factors, and decrease opportunities by which a handful of people abuse their special position to grab exorbitant profits. Reform measures should include: (a) The pressing task at present is to study and set up standards for fair distribution of public resources, including assets and opportunities. Under the planned, direct income distribution system, urban residents' incomes were determined only by wage scales and region. Under the market income distribution system, the quantity, quality and combination method for 98 Distribution System Reform in the Transition to a Market Economy resources possessed (including assets and personal ability) play a decisive role in income levels. For this reason, people have begun to pay attention to the fairness of resource distribution. We should set up a system for rational assessment of and profits from publicly owned resources, enact regulations on bank credits and stock markets, and provide opportunities for the selection of occupations and promotion. (b) We should endeavor as far as possible to reduce monopoly factors in economic activities. We should designate areas for priority development of state- and collective-owned enterprises. Where competitive advantages are lacking, we should allow rivalry among individual industrial and commercial businesses and private entrepreneurs. We should establish special taxes on the business activities of enterprises actually enjoying monopolies and nationalize the majority of excess profits. We should improve management methods for the issuance of licenses, quotas and documents. Bidding methods can be adopted. (c) We should accelerate reform of the land use system, implement a system of land-use charges within contract time limits, restructure the "gray" land market, stop illegal transactions, and establish land market standards. The government will monopolize primary markets for the transfer of land use rights, open secondary markets for the transfer of such rights and set up taxes for value-added in land transactions. The real estate development boom is due, on the one hand, to demand and, on the other hand, to reform not being in place (in Shenzhen where the land system is most successful, land sold has accounted for only 10 percent of that available), making it possible to reap very large profits. (d) We should accelerate reform of the distribution system within the planning structure, and raise remuneration for government functionaries and scientific and technical personnel. We should solve the problem of abnormally low pay for employees at government institutions, especially for scientific and technical personnel, as well as remuneration for the conversion of research results into productive elements. We should begin with structural reform of government institutions and the transformation of government functions. With regard to second jobs, the key lies in successful reform of the labor, personnel and distribution systems within publicly owned units. Since the situations in various work units are different, the decision on whether their employees should be allowed to do part-time work and take on a second job can be determined by various enterprises and institutions themselves. Stipulations on the matter should be incorporated in labor and employment contracts. There should be no uniform state regulations. (e) We should relax control on industrial and commercial registration, decrease obstacles to market entry and reduce the number of unlicensed businesses. Li Yuan 99 We should strengthen market construction, organize market transactions, protect legal businesses and ban illegal ones. F. SOCIAL SEcuRITY With widening income gaps, we must consider citizen tolerance. In the process of reform and development, particularly during periods of inflation, the adoption of effective measures for low-income people and appropriate help for them involves social security. Embodiment of fairness and common prosperity in distribution relies mainly on secondary distribution, which should be implemented through the state social security system. In the original social security system (covering labor insurance, social relief, social welfare, special social care and housing systems), the labor insurance and housing systems were not socialized. At present, the overall plan for old-age pensions for state- owned enterprise employees has now expanded to cover 85 million current workers and staff and 17 million retirees. This measure has eased contradictory unequal burdens on new and old enterprises and guaranteed the livelihood of retirees. However, some basic drawbacks of the original system have not been eliminated. First, it only covers the employees of publicly owned units and their families, and is thus unsuitable for diversified economic development and the free flow of the labor force. Second, the state is completely responsible for the collection of social security expenses. Third, the problem regarding the maintenance of value of various accumulated social security funds has not been resolved. In 1991, the pension fund balance stood at Y 13.8 billion. Fourth, the relative isolation between administrative departments resulted in high costs and low efficiency. Although housing system reform has started in 24 provinces and cities, long- term efforts are required to solve the problem of low rents and serious housing shortages. Orientation for New Policies. The emphasis should be on reform of the social insurance and housing systems and the establishment of a social security system that meets the needs of a market economy. Since social insurance and public housing are in the public domain, the responsibility for collection of funds must be shared by the state, enterprises and individuals. High efficiency and safety are necessary for the management of such public funds. Under the nation's current economic conditions, they cannot be used completely free of charge. Reform measures should include: (a) Old-Age Insurance. In order to accelerate the process of overall reform, we have chosen Guangdong, Fujian and Hainan provinces and Shenzhen and Xiamen cities with their relatively developed, diverse economic sectors to test old-age insurance systems. The social security system has gradually expanded to cover all of society. Responsibility for the collection of funds is shared on a rational basis by the government, enterprises and individuals. Operation of the security system has been socialized. Administrations have been made uniform to suit the needs of the market economic system and 100 Distribution System Reform in the Transition to a Market Economy those of the flow of labor. It is also necessary to solve the issue of use of accumulated funds so as to both preserve and increase them. (b) Unemployment Insurance. The unemployment insurance system has improved somewhat in recent years. The scope of use of unemployment insurance premiums in state-owned enterprises has expanded to cover workers and staff made redundant by the closure of their firm or in the event of a halting of production for consolidation with provincial or municipal government approval. Some regions have raised levels for unemployment insurance premiums. Some localities have instituted an unemployment insurance system for enterprises under various forms of ownership. However, mere reliance on unemployment insurance is far from adequate to solve the placement of surplus personnel. It is still essential to promote the tertiary sector, develop the labor market and encourage enterprises of diverse ownership in order to provide employment through multiple channels. Various localities have devised measures and policies for arranging groups of surplus enterprise personnel, including training, creation of service-sector businesses, retirement of those over the legal age limits, early retirement, dismissal of female workers, temporary suspension of salaries with abolition of jobs, self-employment and the setting up of labor markets. At present, state-owned enterprise employees have relatively low wages and unemployment insurance premiums are related to wage levels. There is a too large an income gap between workers waiting for jobs and those at their posts. Enterprises have difficulty in laying off workers, resulting in large surpluses in unemployment insurance premiums. We can consider using part of the value of public assets in assisting retrenched surplus enterprise personnel. (c) Medical Insurance. In the reform of the free medical treatment and labor insurance medical systems, personal responsibility for a portion of medical fees has progressed rapidly in the past few years. Over 80 percent of enterprises have implemented labor insurance and medical systems. The undertaking of overall arrangements for the treatment of serious illness is burgeoning. However, this alone does not constitute comprehensive reform, nor does it suffice to control irrational growth of expenses. It is necessary to establish, in both supply and demand, a mechanism for improving services and reducing losses and waste. In cities and towns, we should develop a medical insurance business to meet the development needs of diverse economic sectors and of residents who formerly did not enjoy free medical care, labor protection or medical treatment. In the countryside, we should set up cooperative medical insurance. (d) Housing. The housing system reform must conform with the level of development in various localities and must suit the local citizens. We Li Yuan 101 should encourage a diversity of methods, including rent increases, fund- raising for housing construction, sale of public housing and compensated allocation of housing. We should make use of resident funding to improve housing conditions and achieve the objectives of housing reform. (e) The above-mentioned reforms must be coordinated with reform of the wage system. At present, the proportion of welfare income in personal earnings is overly large. Nonwage income is estimated to exceed cash wage income. We should raise the level of personal cash incomes and appropriately reduce the average level of welfare income. (f) We should consider setting a minimum wage standard. Arrangements should be properly made for enterprise workers and staff reductions. In bankrupt enterprises we should protect the rights and interests of workers. Subsidies should be granted to low-income families and families with special difficulties. Athar Hussain and Nicholas Stern on Li Yuan 103 COMMENTS ON "DISTRIBUTION SYSTEM REFORM IN THE TRANSITION TO A MARKET ECONOMY" by LI YUAN Athar Hussain and Nicholas Stem 1/ A. INTRODUCTION Mr. Li has covered a wide range of issues and raised a number of very interesting points; our comments concentrate on the following four in sequence: (a) Direct government control over incomes has become weaker. The government's share of national income has dropped sharply, and there has been a steep rise in the household share and a slight rise in the share of collective institutions. (b) The sources of personal income have multiplied, especially in urban areas. Aside from wages from principal employment, households or individuals also obtain income from second jobs, self-employment, interest and increasingly from dividends and the sale and purchase of land and stocks. The economic reforms have widened income differences between occupations. In particular, the income of government employees has lagged behind the income of enterprise employees. The employees who have been left behind are trying to catch up by supplementing their main income from alternative sources, including "irregular self-compensation." (c) Although the Chinese population has come to reject the extreme egalitarianism of the prereform period, it still remains highly sensitive to fairness and justice in the distribution of personal income. There is widespread social resentment against very high income earned by some individuals. (d) The government should rely on the personal income tax to influence the personal distribution of income, and reform the social security system to protect low-income households or individuals. B. SHIfTr IN THE DISTRIBUTlON OF INCOME An increase in the share of national income going to households and (nongovernmental) collective institutions is in keeping with the spirit of market-oriented reforms, and seems to have taken place in all economies undergoing the transition to a market economy. It may even rise further with a further development of a market economy. We do not regard the rise as a problem. Rather the problem lies in the delay 1/ Athar Hussain is Associate Professor, London School of Economics and Nicholas Sterm is Chief Economist of the European Bank for Reconstruction and Development. 104 Comment in taking account of its implications for macroeconomic policy and the public finances. In the prereform economy, the government controlled both wages and prices, which served to keep the share of income going to households low. The weakening of government wage control and a devolution of wage determination to the enterprise management, which has been a central component of the economic reforms, has increased the bargaining position of wage labor. As pointed out by Mr. Li, managers, rather than resisting, try to increase the wages of their labor force. The removal of price controls has served to increase the income of the self-employed and farmers, and, generally, the wage-employed have been fully compensated for price rises. An analysis of distribution and its implications in the present-day Chinese economy has to start with two presumptions: first, government control over functional (between wages, profits and rents) and personal distribution is much looser than in the past, and, second, the government has to rely on alternative means of influencing the distribution of income other than on direct administrative controls. Turning to the macroeconomic implications of the rise in the share of households, it has not adversely affected investment. On the contrary, the investment ratio during the 1980s has been higher than in the 1970s thanks to an increase in the propensity to save of Chinese households. However, a satisfactory explanation of the high saving ratio, which is important for the conduct of macroeconomic policy, has yet to be given. Generally speaking, since the early 1980s, Chinese households have tended to spend less than they earn, and, in contrast, the government and the enterprises sector have tended to spend (including investment) more than their income or tax receipts. As a result, the ratio of accumulated savings (or the wealth) of households relative to national income has risen steeply. Partial evidence of this is a spectacular rise in the ratio of household bank deposits to national income. This and the rise in the share of households in national income means that the decisions of households have a much larger impact on the macroeconomic behavior of the Chinese economy now than they did in the past. In this respect, two sets of households decisions are of special importance: (a) the decisions influencing the proportion of income to be spent; (b) the decisions about the forms in which accumulated savings (wealth) are to be held, for example, cash, dollars (American or Hong Kong), bank deposits, bonds, shares. Both sets of decisions are crucially affected by the expectations of households about the future course of inflation and the rate of return on assets. This has crucial implications for the conduct of macroeconomic policy in the present-day Chinese economy. In the past, the government and enterprises (which were under government control) controlled a large part of aggregate expenditure and held almost all wealth. Beyond guaranteeing an adequate supply of basic necessities to households, the government did not need to pay much attention to consumption and savings decisions of households in its conduct of macroeconomic policy. But now, the conduct of macroeconomic policy is much more complicated by the fact its outcome depends crucially on the decisions and expectations of households. This, we would argue, is one of the major implications of the Athar Hussain and Nicholas Stern on Li Yuan 105 shift in the distribution of income outlined by Mr. Li and is not fully taken into account in the conduct of macroeconomic policy. We turn now to the implication of the shift for the public finances. As argued in our comments on the paper by Messrs. Xu Shanda and Ma Lin, it calls for a radical overhaul of the tax system. The share of taxes paid by households has to rise if the trend toward a steady decline in the ratio of taxes to national income is to be reversed, though we would also emphasize that a reform of the public finances should include both the in-budget and the off-budget revenue and expenditures, which has risen sharply. C. MULTIPLCATION OF INCOME SOURCE AND INTEROCCUPATIONAL DIFFERENCES The multiplication of the sources of income has important implications for both the tax system and the measurement of inequality. A generally accepted argument in economics is that when individuals derive income from a variety of sources and are capable of influencing the form in which they receive income, the personal income tax should treat all forms of income equally as far as practicable. Although the income from the sale of labor is by far the most important source of income, one should take into account all sources of income when measuring income inequality. Second jobs and supplementary sources of income do not raise special problems for welfare, but in certain cases they may have an adverse implication for labor efficiency depending on the extent to which they detract from the performance of the main job. If they do, then efficiency can be increased by raising wages for the main job, and low wages that force employees to look for supplementary sources of income can turn out to be highly unproductive. The solution to adverse effects of the fall in the incomes of government employees would seem to lie in a rationalization of government agencies and an increase in the tax revenue so that the government can pay its employees enough. Low pay for government employees is likely to be both a source of inefficiency and an encouragement for corruption. D. ECONOMIC INEQUALITY AND POVERTY Since the level of welfare depends on both the distribution of income and its level, it is important to distinguish between inequality and poverty. It is possible for poverty to decline while income inequality increases. However, it is important to point out that economic growth does not automatically reduce poverty. If it did, then there would no poor in developed economies. Moreover, a rise in inequality puts limits on a reduction in poverty. To give an example, if the share of the bottom 20 percent of the population falls from 12 to 10 percent of total income, then per-capita income has to rise by 20 percent just to keep the living standard of the bottom 20 percent of the population constant. The idea of letting a few get rich first and others to follow later is highly practical, especially in a large and a diverse economy such as the Chinese. But it is important to emphasize that it leaves open the issues of, first, whether others will catch up, and, second, how long it would take them to catch up. The implication is that even when an increase in inequality is socially acceptable, there still remains an important role for a redistributive policy and a social security system to protect the vulnerable groups. 106 Comment Progressive income taxation covering the main income sources is a central instrument for reducing income inequality. But it is important not to exaggerate what it is able to achieve. In developed market economies such as the United Kingdom, progressive taxation seems to have relatively little impact on the distribution of income. A large part of the reduction in inequality comes from social security transfers, such as pensions, unemployment benefits, income supplements and child allowance, and social expenditure on health. Thus, we would emphasize the role of the social security system and social health care in reducing inequality and preventing poverty. The Chinese economy has relied heavily on subsidized prices and guaranteed employment for the maintenance of income in urban areas. These are being phased out as part of economic reforms. Grain and cooking oil prices have been raised substantially and housing rents are being increased. China will, in the future, need some form of cash transfer scheme to prevent poverty and keep income inequality in check. To conclude, we would draw attention to some dimensions of distribution that are not discussed in the paper. These include the inequality between urban and rural areas, which after an initial fall seems to be rising again, and the inequality between regions and provinces. Su Ning 107 CHINA'S INDUSTRIAL POLICY DURING ECONOMIC SYSTEM TRANSFORMATION Su Ning 1/ A. INTRODUCTION After the start of reform and opening up, China introduced an industrial policy concept borrowed from countries practicing a market economy and gradually used it in economic regulation and control. Over the past dozen years or so, we have had some successful experiences and some problems. On the basis of contrasting the foreign concept of industrial policy and in light of the characteristics of China's economic system during the period of its transformation, this paper tries to explore the goals and basic framework of China's industrial policy for the future. B. THE BAsIc CONCEPT OF INDUSTRIAL POLICY Internationally, there are a variety of explanations of industrial policy. In its broadest concept, industrial policy is the general policy formulated by the government in order to achieve the country's goals for economic or industrial development and, through the government's conscious intervention in the economy, to avoid any possible harm caused by imperfect market mechanisms to the country's overall interests, or to accelerate economic development at a lower cost. Industrial policy is different from ordinary macroeconomic policy. The latter stresses short-term regulation of total demand; the former emphasizes long-term control over supply. Formulation of an industrial policy originates from market failure. When there exist monopoly and incomplete competition, and when the market mechanism is not perfect, the market cannot produce a rational distribution of resources by itself and thus needs appropriate government policy intervention in order to safeguard the interests of society. As for less-advanced countries, formulation of an industrial policy originates from the theory of "delayed superiority." The less-developed countries can no longer simply allow a spontaneous market role and the time needed to undergo a comparatively long process of evolution. Rather, through government intervention, planners consciously study and draw on the experiences and lessons of advanced countries in their economic development, and directly use mature technology, modern structure, economic scale; realize economic development at a lower cost and within a shorter time; and implement the strategy of catching up and overtaking. An industrial policy is formulated to meet the actual needs of economic development. Its contents may differ vastly in different countries or at different stages of economic development in the same country. Judging from the situation in various 1/ Su Ning is a division chief in the Research Office of the State Council. 108 China's Industrial Policy During Economic System Transformation countries, the major contents of industrial policy are industrial structure policy and industrial organizational policy. Industrial structure policy means that within a specified time period, the government formulates policies in order to promote the readjustment, development and transformation of a country's industrial structure. These primarily include supportive industrial policy and industrial readjustment policy. The former encourages, stimulates and protects the development of a particular industry; the latter means actively readjusting the declining industries in the course of economic development and transformation of the industrial structure. Industrial organizational policy aims to improve market order, promote effective competition and give an effective role to the market in resource allocation. In its actual application, industrial organizational policy usually comprises two contrasting sets of policies. One is the antimonopoly policy for protecting competition and the policy supporting medium-size and small enterprises; the second is the industrial union and group formation policy based on large-scale management and prevention of transitional competition. Although an industrial policy stresses government interference in the economy, these interventions do not constitute direct interference in enterprise management. Rather, indirect means are used and, through the market mechanism, they influence an enterprise's economic actions and strengthen its development. At the same time, the formulation of an industrial policy must conform with market laws, which must be abided by, whether in industrial structure readjustment or in organizational readjustment. Therefore, to a certain extent, an industrial policy is a conscious application of market law. C. CHINA'S INDUSTRIAL POLICY AND EXISTING PROBLEMS In the broadest sense of the phrase industrial policy, all the industrial development policies we formulated under the planned economic system are industrial policies, over the nearly 30 years from the founding of the People's Republic of China to the reform and opening up in 1978. These policies have played an important role in accelerating the process of China's industrialization, promoting economic development and initially establishing a structurally complete industrial system. However, as with the traditional planned economic system, the authorities have found it increasingly difficult to meet the needs of China's socialist economic development using these policies. After implementation of reform and opening up, along with the gradual transformation of the entire economic system to a socialist market economy, the study of China's industrial policies and the formation of policies have entered a completely new stage. Many domestic and foreign scholars, drawing on foreign experience and in light of the concrete characteristics of domestic structural reform and economic development, have conducted thorough studies of the theory, framework and methods of China's industrial policies and have done a great deal of the groundwork in the formulation of China's industrial policies. The Chinese government also used industrial policies as an important means for regulating economic development and, in March 1989, formally promulgated the State Council's Decision on the Main Points of Current Industrial Policy. It stated: "While reducing and controlling total demand, we should readjust and transform Su Ning 109 the industrial structure; improve the quality and efficiency of the national economy; concentrate resources on developing agriculture, energy, communications and raw and semifinished materials industries; strengthen industries capable of increasing the supply of essential products; and increase the potential for economic growth. At the same time, we should control the development of ordinary processing industries so that their development is coordinated with the growth of basic industries." This industrial policy, under the particular historical background of economic improvement and rectification, has played an important role in stabilizing the economy and readjusting the structure in coordination with other macroeconomic policies. However, it must be noted that the results of implementation of these industrial policies are far from ideal. What is more, from the perspective of developing a socialist market economy, it is not difficult to discover that the goal, principles and means of these policies still carry deep vestiges of the old system. A fundamental change is needed in our guidelines. These problems are manifested mainly as follows: (a) More stress on the formulation of a policy for readjustment of the industrial structure, which neglected the fact that an industrial policy is a combination of various policies for supporting industrial development and failed to work out a systematic industrial policy in light of the main problems in China's industrial development. The result is that the policy is one-sided. (b) The industrial structure readjustment policy is manifested mainly in a listing of priority subsectors for industrial development. The catalog included almost all industrial departments, attending to each and every one of them; it lacked priorities and the selection of a strategic goal for industrial development and, on this basis, failed to set the orientation and approach to readjustment of the industrial structure. (c) The method for readjustment of the industrial structure was only a general principle; it failed to offer policy means for concrete and effective support of readjustment of the industrial structure in light of the characteristics of the present system. Apart from the above-mentioned defects, there are two problems that merit our special attention. First, previously, in formulating an industrial policy we usually stressed forms to the neglect of their market foundation. The industrial policy stressed government intervention in the economy, but its foundation should be the market environment. Government intervention has to be realized ultimately through improving the market mechanism and mobilizing entrepreneurship. Overlooking this basis in studying and formulating the industrial policy will possibly bring us back to the old ways of a traditional planned economy. Second, government intervention will entail "government failure." Government judgment may be mistaken; the government intervention policy may be wrong. Sometimes the price paid for "government failure" is-even greater than that for 110 China's Industrial Policy During Economic System Transformation "market failure." In China, this problem stands out prominently. Now that China is in a period of transformation of the economic system, an important task is to reduce unnecessary government intervention in the economy. We should be wary of the practice of safeguarding excessive government interference in the economy in the name of industrial policy. Earlier, in the process of implementing China's industrial policy, many places adopted diverse policies to support the development of local industries and carried out readjustment of similar industrial structures. This, to some extent, entailed new redundant and decentralized construction. In the formulation of the country's industrial policy, there also clearly existed problems of underestimation of development of major consumer goods and inadequate understanding of strategic industries, entailing "government failure." This confronted the formulation of China's industrial policy with more challenges. It requires us to carefully use government intervention to solve "market failure," and at the same time actively establish a market environment and expand the role of the market mechanism to solve "government failure." D. MAIN FEATURES OF CHINA'S ECONOMIC SYSTEM DuRiNG SYSTEM TRANSFORMATION An industrial policy cannot be worked out in isolation from the present economic system. After nearly 15 years of reform and opening up, particularly after the remarks given by Deng Xiaoping during his southern China tour in 1992 and the 14th National Congress of the Chinese Communist Party, establishing a socialist market economy has become the common understanding of the whole Party and people of the entire country. The pace of reform and opening up should be further accelerated. The old system is being gradually broken down and a new system is being gradually established and perfected, forming a special background for the formulation of an industrial policy in the future. The main characteristics are as follows: (a) The role of central government planning is being further reduced. The state's mandatory production plan and the material distribution plan are being reduced considerably. In 1993, the proportion of the mandatory industrial production plan in total industrial output value, under the charge of the State Planning Commission, will drop from 12 percent to 7 percent. Materials distributed under the unified state plan have decreased from prereform figures of 256 kinds to 19 kinds. State planning control is manifested mainly in the examination and approval of investment projects, the use of foreign exchange as well as the planned distribution of bank loans. (b) Continued decline of the proportion of financial revenue in national income. In 1991, state financial revenue accounted for only 18.1 percent of gross national product (GNP), of which central financial revenue made up 35.1 percent of the state total. The central government's ability to control the national economy has become weaker. Su Ning 111 (c) Local authorities maintain great control over economic development. With power delegated by the central government to lower levels, local government economic management power has increased. The dynamics of their direct interference in the economy is in inverse proportion to the administrative level; the lower the level, the stronger is the management power. This is especially true since the introduction of the system of "eating from different kitchens," namely, the system of dividing revenue and expenditures between the central and local governments and holding each responsible for balancing their budgets. This principle has strengthened the motive for local government intervention in the economy. (d) Gradually expanded decision-making power of state-owned enterprises. Most state-owned enterprises continue to use the contract responsibility system. While fulfilling specified, contracted base figures, enterprises can engage in independent management and have a certain ability to develop themselves. But at the same time, the relationship between enterprises and the state has not been really rationalized. The acts of government at all levels interfering in enterprises and the phenomenon of enterprises depending on the government for their losses coexist simultaneously, and an environment for equal competition among enterprises is still lacking. (e) Formulation of a preliminary pricing mechanism. With the exception of very few important products that affect the national economy and people's livelihood, currently the prices of 90 percent of consumer goods and about 70 percent of capital goods have been decontrolled, and are being regulated by the market. As to the few products whose prices have not been liberalized, their prices are being gradually readjusted and are slowly becoming reasonable. (f) Various types of markets are being actively developed, but have not yet become mature. Consumer goods and capital goods markets have been further developed. The markets of capital, foreign exchange, real estate, labor and technology are in the stage of initial establishment. Market regulations are far from perfect and a national unified market has not yet taken shape. E. MAIN PROBLEMS FACING CHINA'S INDuSTRIAL DEVELOPMENT Over the past 40-plus years since the founding of the People's Republic of China, especially since the reform and opening up in 1978, China's economic strength has been greatly increased. At present, we are faced with a good opportunity for accelerating economic development. However, China's industrial development is confronted with many problems, which are manifested mainly as follows: (a) The serious lagging behind in the development of basic industries. Energy, raw and semifinished materials production, posts and 112 China's Industrial Policy During Economic System Transformation telecommunications, especially communications and transportation, have currently become factors restricting China's economic development. Because the prices and charges for the products of these industries are low, the volume of investment funds needed is large and the investment period is quite long. There is currently an inability to attract funds for investment, so these areas are the weak links of development. (b) Indistinct orientation for industrial readjustment. Now that people's basic needs have been fundamentally met, color TVs, refrigerators, washing machines and other durable consumer goods have become popular in cities. In the 1980s, light, textile and durable consumer goods industries that supported rapid economic growth were restricted by market demand. For the 1990s through the early period of the twenty-first century, policymakers have not yet reached a common understanding of the orientation for the readjustment of China's industrial structure and of the leading industries that will support the accelerated growth of the national economy. The present, rapidly developing boom of investment is, to a large extent, "blind" development. It will possibly entail a serious structural imbalance of supply and demand. (c) Scale not economic. As a result of the self-development of local economies and the survival without bankruptcy of older enterprises, it is difficult for funds to flow between enterprises and between regions. The lack of a unified national market and competition between regions has led to an uneconomic scale of production. Presently, since decentralized and small- scale investment and irrational redundant construction still continue, the reorganization of capital is rather difficult. (d) Low economic efficiency. The pursuit of a high growth rate of production rather than improvement of efficiency remains a serious problem in China's economy. China's labor productivity and the utilization efficiency of energy and funds is much lower than those of other newly emerging industrial countries. This has led to China's use of a higher rate of accumulation and a large volume of investment in return for the same level of economic growth. At the same time, low efficiency has offset the advantage of low labor costs and resulted in a lack of international competitiveness of its products. (e) Old enterprises, beset with difficulties, find it hard to develop. Most of the large- and medium-size state-owned enterprises set up during the period of the planned economy have aged. In the past, the state exercised unified control over income and expenditures. Enterprises turned over all profits to the state, which were then used in building new projects. Enterprises had no funds to implement necessary technical transformation. At present, these enterprises' equipment is obsolete, their technology and products are outdated and their employees are old, so they face great difficulties and their Su Ning 113 tax burden is unequal. These enterprises occupy a large proportion and hold an important position in the economy. How to develop them and infuse fresh life into them has become a major problem. (f) Coexistence of a low general technological level and new high technology. Over the past dozen years or so, the introduction of technology has greatly raised the technical level of Chinese enterprises. However, there is still a large gap between the general technical standard of Chinese enterprises and that of foreign ones. At the same time, some imported high and new technologies cannot be put to full use because of the inability to assimilate them. In particular, the import of labor-saving technologies hinders efforts to take full advantage of China's abundant labor and wastes scarce financial resources. (g) The degree of trade liberalization is lower than that of capital liberalization. The defects of the export system and trade protection have obstructed domestic enterprises' active participation in international market competition and protected these enterprises' low level of technology and efficiency. The preferential policies offered by various localities in the scramble to expand the import of foreign capital have resulted in the formation of an environment of unequal competition between domestic and foreign enterprises and in the lopsided development of some foreign enterprises that take advantage of China's trade protection and incomplete regulations. F. THE BASIC FRAMEWORK OF CHINA'S INDUSTRIAL POLiCY DuRING THE PERIOD OF TRANSFORMATION OF THE ECONoMIC SYSTEM The basic principles for the formation of China's industrial policy in a future period are as follows: (a) We will formulate China's industrial policy on the basis of national conditions and in light of the special background of China's system during the period of economic transformation and the practical problems facing industrial development. (b) We will emphasize the role of the market in the allocation of resources, abide by market laws, encourage competition on an equal footing, stimulate entrepreneurship, and promote industrial development. (c) We will bring the government's role in controlling the economy and, through the government's conscious application of economic law, overcome the limitations of the market, make use of less-developed countries' delayed advantages, promote rejuvenation of the economy and the catching up process. The government's economic control must be conducive to developing the positive role of the market mechanism. 114 China's Industrial Policy During Economic System Transformation (d) We will correctly handle the relationship between direct and indirect control. While primarily using legal, financial, taxation, banking and other indirect regulatory means, we will also adopt necessary direct regulatory means as long as the market environment has not yet been perfected. (e) Formulation of the industrial policy should be coordinated with reform of the economic system. In light of the above-mentioned principles, in a future period, China's industrial policy can roughly include the following contents: (a) Accelerate readjustment of the industrial structure. The emphasis is on accelerating the development of basic industries and promoting the upgrading of the industrial structure in the next decade. We will provide necessary supportive means to accelerate the development of energy, raw and semifinished materials production, posts and telecommunications, particularly communications and transportation, expanding the proportion of investment in these departments in the total public investment. We should establish an investment funding system and, through long-term policy-related financing banks, concentrate funds and invest them in the above-mentioned basic sectors. On the basis of careful analysis of the demand structure in the 1990s, we should establish the orientation for readjustment of the industrial structure, accelerate the development of value- added industries and promote the upgrading of the industrial structure. It is particularly necessary to set up leading industries that can promote growth of the national economy, and appropriately encourage investment in these industries, so that they can start at a high level and develop on an economic scale. (b) Develop a dual structure under which capital intensity and labor intensity run parallel. We should increase investment intensity for single projects, encourage enterprise mergers and appropriate concentration and specialization of production, and accelerate the formation of a scale economy, so that enterprises can participate in competition at a higher level. These are important ingredients of industrial organizational readjustment in the 1990s. This is not only conducive to raising enterprises' technical level, reducing costs and improving efficiency, it is also an important step toward promoting the modernization of China's industries. To achieve this goal, besides adopting a policy to encourage large-scale management, we should set up barriers to the entry to certain trades and products, reduce local government's administrative intervention in production and investment and promote the formation of a unified national market. While encouraging large-scale management, we should make full use of China's abundant labor force, promote the development of medium-size and small enterprises, especially township enterprises, and develop labor-intensive enterprises. We should formulate necessary policies, encourage township enterprises to Su Ning 115 develop processing of agricultural and sideline products and products that provide relevant services for large- and medium-size enterprises as well as products for export, and continually raise their technical level and upgrade their products. (c) Accelerate development of a unified national commodity market and factor market, and establish an environment for competition on an equal footing. This is an important ingredient of the industrial policy during the period of economic transformation. At present, dependence on direct government planning cannot solve irrational, scattered and redundant construction as well as the similarity of regional industrial structures. Only through establishment of a unified national market and through competition on an equal footing can we overcome regional isolation, reduce irrational investment and low-efficiency production. This also means solving "government failure" by a market method. We should continue to reform the irrational pricing system; set up a unified commodity market and markets for capital goods, capital, technology, and labor; reduce various barriers that hamper the flow of products and production factors; improve transportation and communications systems; develop the information transmission system; encourage the establishment of transregional, transprovincial companies; and change the irrational system wherein enterprises are affiliated to localities. (d) Formulate industrial and technical policies suited to China's national conditions. While continuing to import an appropriate amount of high and new technology, we should put emphasis on expanding the development, introduction and popularization of applied technology and generally raising the technical standard of industries. China is short of funds and rich in labor, but its technical level is relatively low; the equipment and technology in numerous large- and medium-size state-owned enterprises is outdated and in urgent need of updating; many newly established township enterprises continue to use outdated and even obsolete technology and equipment. In formulating industrial and technological policies, we should, in light of these characteristics, encourage and develop new technologies that are easy to popularize and can save funds. We should pay attention to the commercialization of technology, encourage the combination of research units with enterprises as well as the flow of technical personnel. We should quickly turn more research results into new productive forces. (e) Accelerate the trade liberalization process. We should take advantage of the pressure of international competition to raise the competitiveness of domestic industries and promote the growth of domestic markets. We still need to give certain protection to China's industries at the present developmental level. But excessive protection can only entail the lopsided development of domestic industries and result in a low level of competition and low efficiency. Although accelerating trade liberalization will subject 116 China's Industrial Policy During Economic System Transformation domestic enterprises to the tremendous pressure of international competition, it finally will help raise enterprises' competitiveness and expand exports. At the same time, it helps formation of a competitive market environment and overcomes domestic decentralized and redundant construction. Trade liberalization should be designed to take account of China's national conditions and be carried out step by step. Industries already possessing a certain degree of competitiveness may have their protection removed first. Infant industries that are important for the country's development prospects should have a timetable for a period of limited protection, during which they should accelerate development and gradually have this protection eliminated. (f) Formulate policies facilitating the development of domestic industries and the use of foreign capital. The ultimate aim of introducing foreign capital is to promote the development of domestic industries. Since the reform and opening up in 1978, China has had many achievements in its utilization of foreign capital. However, there also exist some problems. With the gradual increase in China's ability to attract foreign capital, it is necessary to conscientiously sum up experiences and systematically formulate China's policy for the use of foreign funds. We should adopt a method that provides a good investment environment and market environment to replace the practice of merely using various preferential policies to attract foreign funds. At the same time, we should gradually put foreign enterprises and domestic enterprises in an environment of competition on a roughly equal footing. We should set up a list of priority industries for attracting foreign capital so as to promote the improvement of the domestic industrial structure and improve the funding structure by use of foreign capital. (g) Support economic development in the central and western regions, while encouraging coastal areas to accelerate development. Promotion of common prosperity for people in various regions is a goal of a socialist market economy and a prerequisite for social stability. It should be regarded as an important ingredient of the industrial policy. To support the development of the central and western regions, it is necessary to create an environment for competition on an equal footing. For example, we should raise the present low prices for energy and raw and semifinished materials, and enable these regions, where energy and raw materials production are concentrated, to earn reasonable incomes. The state should also formulate a policy to give them necessary support by, for example, increasing financial subsidies to economically backward regions, formulating some preferential policies for their economic development, appropriately increasing investment to improve their communications and transport environment and post and telecommunications networks of these regions, and formulate preferential policies to attract funds, technology and professionals from coastal areas. Su Ning 117 (h) Adopt policies and measures to support the development of old enterprises and old industrial bases. Apart from accelerating the transformation of enterprise operating mechanisms and implementing a fair enterprise tax burden, it is still necessary to provide support to help restructure enterprises, replace their backward equipment and raise their technical level. It is necessary to change the present method of keeping loss accounts and passive subsidies. Through necessary financial means as well as providing for noncommercial loans, restructuring should be carried out in these enterprises within a specified time limit. At the same time, it is necessary to adopt a principle of promoting the efficient and limiting the inefficient, of relying on a method of stimulating entrepreneurship to prevent the emergence of a new egalitarian practice of "eating from the same pot." Nicholas Lardy on Su Ning 119 COMMENTS ON "CHINA'S INDUSTRIAL POLICY DURING ECONOMIC SYSTEM TRANSFORMATION" by SU NING Nicholas R. Lardy 1/ A. INTRODUCTION Su Ning's paper on industrial policy in the transition period is very insightful and raises many issues. I would like to discuss three: the structure of Chinese industry, the sources of export growth, and the role of foreign trade in industrial policy. B. THE STRUCTURE OF INDUSTRY Centrally planned economies frequently are said to be overindustrialized and reform is expected to lead to substantial changes in the structure of industry. For example, declining manufacturing output in Eastern Europe and the former Soviet Union is attributable in part to a fundamental shift in final demand that has reduced substantially the demand for products of the steel, machinery, and chemical branches of industry. Thus, falling output in these sectors is a necessary part of the transition to a more market-determined pattern of demand. Declining industrial output, in this view, should not be cited as evidence of the failure of the transition strategies of these states since in large measure it is due to a necessary shrinkage in these overdeveloped industrial branches. Although China in terms of its population structure was more agrarian at the outset of its economic reforms than any of the other reforming socialist states, it too in some sense was overindustrialized. In China a disproportionately large share of gross domestic product originated in manufacturing. And within manufacturing China had unusually large concentrations of output in the machinery, chemical, and metallurgy industry branches. Paradoxically, although China's industrial growth was unusually rapid in the first decade and a half of reform, there appears to have been little change in the structure of output. The share of light industry, including food processing, textiles, apparel, leather, paper, and cultural goods, if anything, actually appears to have declined. Comparing 1981 and 1990 (which allows us to use output data measured in constant 1980 prices for both years), light industry's share of total industrial output (excluding village level industry) fell I/ Nicholas Lardy is Professor of Economics at the Henry M. Jackson School, the University of Washington, Seattle. 120 Comment from 37.4 percent to 32.8 percent (Rawski 1993, 20).Z/ Incorporating village-level industry, which by 1990 accounted for 10 percent of manufactured goods output, modifies this picture only slightly. The shares of building materials and apparel were higher and those of metallurgy, electricity, coal, and petroleum distinctly lower, but otherwise the output composition was similar. Has the shift toward a market-oriented economy over the past decade and a half led to no significant changes in the structure of demand? Or have changes in the structure of demand been limited, leading only to changes in the mix of output within each of the 15 branches of industry? Or has state industrial policy inhibited structural change among industrial branches? Among these three alternatives, Singh's analysis supports the latter. He argues that despite substantial changes in the investment system since the beginning of reform, investments in various branches "appear to have been allocated on the basis of fixed relative shares" (Singh 1992, 3). If investment had been more responsive to changes in demand or had been based on market criteria there would have been a substantial change in the composition of investment and subsequently in the structure of output. Mr. Su's paper, particularly in its discussion of the insufficient development of the market in the formulation of industrial policy, seems also to support this view. The relatively fixed pattern of investment is also evident in the key infrastructure sectors: energy and telecommunications. Although there has been much concern that these sectors are bottlenecks to increased industrial production, their shares of total fixed asset investment barely changed between 1981 and 1987 (Singh 1992, 34) Mr. Su's paper mentions this problem, attributing it to continuing price distortions. The same nonresponsiveness to changes in final demand may have been true even within individual branches of industry. Steel output, for example, more than doubled in the 1980s. But the mix of products evolved only slowly. The result was that inventories of unusable domestically produced crude steel rose several million tons annually, while imports of various specialty steel products soared to reach more than 8 million tons by 1989. C. THE SouRcEs OF EXPORT GROWTH One of the most notable changes in the structure of demand in China in the 1980s was a sharp increase in exports. The value of exports soared from $18 billion in 1980 to $85 billion in 1992. While conventional calculations of exports as a proportion of gross domestic product substantially overstate the increasing importance of exports as a source of final demand in the Chinese economy (Lardy 1992, 150-155), there is little 2/ Chinese practices for classifying industrial output may lead to a substantial distortion in the reported proportions of light and heavy industry. In principle, metal and machinery products for daily use (including consumer durable goods such as fans, refrigerators, washing machines, and so forth) and household electronics should be classified as light industrial output. In practice, these products are frequently produced in firms that mainly manufacture heavy industrial products. In many cases, these firms appear to report all of their output as falling under heavy industry. Nicholas Lardy on Su Ning 121 doubt that increased openness of the economy was one of the most important sources of changing final demand facing Chinese producers. Yet it would appear that the response of Chinese firms, particularly state-owned manufacturing firms, to this changing demand has been quite slow. In contrast, foreign-invested enterprises have become an increasingly important source of goods for the export market. Their share of total exports increased from 8.3 percent in 1989 to 20.4 percent in 1992. From 1990 through 1992 foreign-invested firms were responsible for more than half of all incremental exports. Yet these firms' share of output remains extremely small, under 5 percent of manufactured goods output and only 1 to 2 percent of gross domestic product. Township and village enterprises have also made disproportionately large contributions to export growth. The growth of exports from China has been impressive in large measure because of relatively liberal foreign investment policies that have attracted large numbers of wholly foreign-owned firms, joint venture firms, and contractual joint ventures. But state-owned firms appear to have been quite slow in responding to the opportunities created by opening up to the outside world. The relationship between industrial structure and exports is further illuminated by examining provincial-level data. Opening to the outside world appears to have had a substantial effect on industrial structure in those provinces that have become major sources of exports. Industrial structure seems to have changed slowly, if at all, in regions where export performance has lagged. For example, Guangdong Province has become far and away the most dynamic exporting province with exports climbing from $1.4 billion dollars in 1978 to $18 billion dollars in 1992. As is well known, by the late 1980s Guangdong's largest export products were predominantly light industrial goods- shoes, garments, cotton piece goods, silk piece goods, plastic articles, and toys. Because of the growing importance of exports in the region the structure of output in the province changed dramatically during the 1980s; the share of light industry increased continually from 57 percent in 1978 to 69 percent by 1990. By contrast, Shanghai's export performance was and remains modest in the extreme, with the value of exports produced in the municipality rising from $2.9 billion in 1981 to only $3.1 billion in 1988. Thus Shanghai's exports rose less than 25 percent while China's total exports more than doubled. Over this period the structure of output changed little in the municipality. Measured in constant prices the share of light industry actually fell slightly from 57.3 percent in 1981 to 54.7 percent in 1990. D. FOREIGN TRADE AND INDUSTRIAL POLICY One of the most obvious linkages between industrial policy and the external sector is export targeting. The state targeted several different sectors for export development in the decade of the 1980s. But none was targeted with such a comprehensive range of incentives as the machinery and electronics sectors. The most obvious element. was a preferential foreign exchange retention rates, beginning as early as 1981 (Lardy 1992, 54-55). 122 Comment At the outset of the Seventh Five-Year Plan, the State supplemented this scheme with a program for the development of export commodity production bases. It provided for special low-interest, subsidized loans for technical transformation of or investment in firms producing for the export market. Machinery and electronics was the first industry group to benefit from this scheme. Between 1986 and 1991 the State channeled Y 2.4 billion in these subsidized credits in support of projects with a total cost of just over Y 4 billion. The annual commitments of low interest-rate loans rose sharply over the period from an annual average of Y 300 million in 1986-89 to Y 800 million in 1991. Third, the State supported exports in the machinery and electronics sector by special export financing schemes. An export sellers' credit facility for machinery and electronics products was initiated in 1978. In 1992, this was supplemented with a new export buyers' credit facility, again exclusively to promote the sale of complete sets of Chinese machinery and electronic equipment. These schemes have contributed to an acceleration of machinery and electronic exports. In 1985, exports of these products were $1.68 billion accounting for only 6 percent of China's exports, according to Chinese customs statistics. By 1992, these exports had expanded to $18 billion and accounted for more than 20 percent of total exports.J/ If the State Council's recently promulgated targets of machinery and electronic product exports of $30 billion in 1995 and $60 billion in 2000 are met, the pace of export growth from these branches will continue to be quite rapid. Success in export targeting, however, must be measured by competitiveness on world markets, not just export growth. Although special export incentive in this sector have been in place for over a dozen years, some evidence suggests that many Chinese machinery and electronic products are not competitive on world markets (World Bank 1993). E. SUMMARY Given the profound changes in the Chinese economy over the past decade and a half, changes in industrial structure appear to be remarkably small. The evidence summarized here suggests that this is not because the structure of final demand has been unchanged. Rather state-owned firms appear to have been slow to change their output mix and the allocation of investment has been somewhat inflexible. Response to increasing export demand has been most noticeable on the part of foreign-invested firms and township and village enterprises. Export targeting appears to be a relatively unsuccessful example of industrial policy, at least in the machinery and electronics sectors. With the probable exception of goods produced by foreign-invested firms, many of these exports would not 2/ A substantial portion of this growth is accounted for by foreign-invested firms that by 1991 exported $4.06 billion of machinery and electronic export products, almost 30 percent of all goods in that category. Nicholas Lardy on Su Ning 123 be saleable on world markets without the substantial export support provided by multiple government programs. References Lardy, Nicholas R. 1992. Foreign Trade and Economic Reform in China, 1978-1990. Cambridge: Cambridge University Press. Rawski, Thomas G. 1993. "An Overview of Chinese Industry in the 1980s," Unpublished Manuscript, February. Singh, Inderjit. 1992. China. Industrial Policies for an Economy in Transition. Discussion Paper No. 143. Washington, D.C.: The World Bank. World Bank. 1993. China Trade Policy. Washington, D.C.: The World Bank. Zhou Xiaochuan 125 REFORM SEQUENCING AND STATE ASSET MANAGEMENT IN CHINA Zhou Xiaochuan 1/ A. INTRODUCTION The popular opinion on reforming socialist economies tends to maximize a reform package of radical measures that are theoretically safe but usually go beyond the capability of management. This paper explores the minimum package that includes necessary, rather than sufficient, measures for reforming a centrally planned economy (CPE) before its crisis becomes unmanageable. In contrast to the reform troika- democratization + marketization + privatization-this paper suggests that the minimum package can contain only marketization and preliminary political reform, with an emphasis on stability. Large-scale and fast privatization, although it appears necessary, is actually time-consuming and politically very sensitive. It cannot support comprehensive economic reform in a timely manner, as economists expect in theory. In the introductory phase of reforming a socialist economy, strengthening or reestablishing the principal-agency relationship, together with clarifying originally vague public/social ownership responsibilities, is a more realistic and reliable method. During this phase, moderate privatization in small business is realistic and useful. An observation on China's economy in introducing reform shows that market competition, implying price decontrol, trade liberalization and reestablishing incentive mechanisms, is more important and effective than privatizing existing enterprises under public ownership. If a gradual process is allowed, reform sequencing should allow time for gradual changes in production quality and trade patterns of transformed business entities, paying attention to maintaining a reasonable household savings ratio. That way, beneficial momentum can help reform to continue. A rational reform sequence can arrange, in the introductory phase, a relatively radical marketization in the fields of price, trade, public finance and the banking system, as well as improvement of the principal-agency relationship in enterprises. The restructuring of property rights may parallel the other changes; however, it is a relatively long process and would contribute more effectively to economic dynamics at a much later phase. B. SOME WESTERN CONCEPTS OF REFORM AND NEEDS IN SOCIAuST ECONOMIES In recent years, one of the Western patterns of reform concept for transforming a CPE to a market economy has become very popular in socialist (or formerly socialist) economies. Typically, the concept can be described as a troika- 1/ Zhou Xiaochuan is vice president of the Bank of China. 126 Reform Sequencing and State Asset Management in China marketization + privatization + democratization-where democratization is the basis of the reform determination, and marketization and privatization should be as radical and comprehensive as possible in a maximum package. The troika is widely understood as necessary and as having sufficient components for reforming socialist economies. Some economists in socialist economies and developing economies also accept these concepts. Here in this paper, we refer to this opinion as G1 (Group 1). Many East European countries have followed the G1 process; some of them have been radical, using the so-called shock therapy of the "Big Bang" type. The troika implies that market-oriented reform in a socialist economy without privatization and democratization, as in China, has to fail; and research on marketization under public ownership has to be of no use. For a while, reform sequencing was a much-debated topic among reform economists and policymakers in socialist economies as well as in some developing economies. The recently widespread GL opinion is to get rid of the headache of sequencing. Two reasons can be heard: (a) The troika and all fields in marketization (price, taxation, public finance, banking, trade, social security, etc.) are logically interlinked and should be implemented simultaneously. (b) Governments in the process of reform are always incapable of managing the transition because of a lack of capacity, insufficient knowledge and professionals, and too many political problems. They might be able to start a reform, but then the process gets out of their control. The implication is that the best choice is to allow all reforms in every field without worrying about sequencing, and to push whatever can be pushed to move. In the process of shock therapy, especially in quick mass privatization, social wealth has to be redistributed. It is almost inevitable that there will be unfair or arbitrary aspects of the redistribution, which is a very sensitive issue in public opinion and interest groups; thus, it can be delicate and widely argued. The G1 also argued that the existing wealth distribution in socialist economies has been arbitrary; so what if one arbitrary distribution is substituted by another. However, the reforms in Eastern European and CIS countries have not been very encouraging. Many critics have appeared to speak about sequencing mistakes. Substituting one arbitrary distribution for another is by no means an easy decision. Meanwhile, the reform in another way is not as bad as the GL predicted. In socialist countries, economists are faced with a different environment containing some nonnegotiable constraints. The Communist Party and its administration may set, in a period, some constraints upon reform, such as continuing with public ownership. It is understandable that the leadership tries to maintain political stability and public calm. Thus, the economists have three choices: Zhou Xiaochuan 127 (a) to say that they do not believe in market-oriented reform under the leadership of the Communist Party and under public ownership; usually outside economists choose this; (b) to be purely observers in the government-led reform process, while taking any possible chance to promote privatization, which implies they doubt the existence of a solution under the given constraints; (c) to participate in and push the reform transition, as well as to try to find some solutions, which implies that they suppose some kind of solution might exist for a certain transitional period under the given constraints. In this environment, like in case of China, market-oriented reform and the abandonment of a CPE can be attempted with constraints as follows: (a) continuing with public ownership and allowing the parallel development of plural ownership; (b) attempting a smooth transition without creating mass chaos; radical measures can be accepted if, and only if, they are very necessary; (c) making wealth redistribution conform to public acceptance, including short- term acceptance. Reform usually started and/or accelerated when some kind of crisis occurred. For example, the reform in China started at the end of the crisis of the Cultural Revolution. Unless a crisis becomes very serious, leadership often tends to choose a gradual transition, which may not the best choice, but is understandable. Also, the public is usually not ready to accept a violent change. Therefore, economists in this kind of situation are invited to solve the problem of providing a minimum package of reform with specific coordination and sequencing of actions. There is almost no room for them to negotiate the basic constraints. So the question becomes whether the minimum package is a solution or not, based on the constraints. For convenience of discussion, we can roughly divide reform economists into two groups (GL and G2). Gi emphasizes the necessity of the reform troika, Big Bang and shock therapy. As a result, the reform package should be as large as possible. G2 supposes there can be a reform solution with a sequencing arrangement under the above- mentioned constraints. They emphasize marketization in the troika, choosing a manageable package at each stage of transition. With the different constraints, and sometimes with different objective functions, solutions and related opinions among G1 and G2 economists and others in different environments diverge. Some observed contradictions between GI and G2 lie in: 128 Reform Sequencing and State Asset Management in China (a) G2 may realize a probability that the political leadership commits to reform and tries to manage the transition. GI may intend there is not a real chance of formulating reform leadership before mass democratization, and a market-oriented transition is beyond the management capacity of socialist leadership. (b) G2 tends to be prudent in redistributing social wealth, keeping in mind social and political stability, which in turn provides a commitment to continued reform and conditions for quick economic improvement brought about by reform. Gl pay less attention to redistribution sensitivity and political stability. (c) G2 realizes there is an enormous amount of change needed in the reform transition process; thus, a strong administrative hand is needed. The democratic decision-making process is too slow to make so many changes. In addition, an inappropriate high speed of democratization may hurt the position of government in managing transition. Leadership may tend to play populist games, which leads to a reduced effort in enforcing the changes. Gl tends to emphasize that democracy provides the correct decision choice of legal entities in a market economy. The role of government can be substituted by a kind of automatic transition process. (d) In Gl's view, G2 is too myopic and pays too much attention to meeting short-term political needs, thereby possibly transgressing the fundamentals of economics. G2 argues that each limited push in reform can accumulate into a significant portion of the transition that keeps reform moving. Negotiation on sufficient political commitment as a precondition to reform may delay some of the actions. C. PRIVATIZATION: IS THERE A QUICK AND EFFECTIVE WAY? Auctioning SOEs Public offering by auctioning state-owned enterprises (SOEs) among investors and the public takes a long time. Potential buyers need a certain amount of time to study disclosed information about a specific SOE. Because of insufficient market mechanisms and misleading accounting rules in the past, they need more time to verify financial data, which have recently been changed to conform with the new accounting rules. Then they compare the enterprise with other SOEs and corporations and make a prediction and judgment about its profit-making capability in competition with other firms in the same sector. (Note: the potential for profit-making or equity appreciation depends on the competitiveness of a specific firm, which is a relative measure. Information about just one SOE is insufficient for making a decision; information about many others is thoroughly studied.) These are necessary steps the potential buyers must perform before they can finally decide upon a price to bid. The preparations on the seller's side, including asset valuation and financial transformation, etc., take time too, but are not emphasized Zhou Xiaochuan 129 here since these jobs can be parallel among several SOEs, if there are enough competent professionals to perform them. But for buyers, the auction process must be sequential. Assuming a quick auction of one SOE can be done in a week, then 52 SOEs can be sold in a year. However, in a large economy such as China's, there are about 4,000 large- and medium-size SOEs. Some regional SOEs can be sold in the region; thus auctions can be, to some extent, parallel. However, buyers do not freely accept an assigned scope of sales where no comparison is available for pricing. Who can be the buyers? Usually citizens, institutional investors and foreign investors. The institutional investors in socialist economies are also state-owned. Those who only believe in real private property rights do not prefer state-owned holding companies; thus, institutional buyers have to be excluded. In the case of China, the estimated total assets of industrial SOEs is about Y 2,000 billion in current prices. The total bank deposits of the population, as the only channel of household saving before the formation of a capital market, is about Y 1,000 billion. It is not clear how interested the population would be in buying SOE shares by withdrawing from their bank accounts. Based on Eastern Europe's experience, at the preliminary stage of reform when many distortions have not been removed, foreign capital is difficult to acquire. Therefore, a real value auction is problematic, not only in speed but also in buyers and sources of money. Employee Participation in Ownership and Management Buyout Employee participation in ownership is another outlet for quick privatization. By reviewing the experiences of worker autonomy in the former Yugoslavia, it is widely accepted among economists that only a small number of shares of a specific company should be sold (usually at a low price) or distributed at no cost to its own employees. However, what constitutes a small number has grown from around 10 percent of total shares to as much as 30 percent. The reason for the increase is probably due to a lack of alternatives for quick mass privatization. The fairness and equality of employee participation in ownership is also questionable. In industries, the capital intensity of different sectors and enterprises is quite different. A worker in a capital-intensive factory (e.g., petrochemical plant) would obtain high-value equity through dividing 30 percent of the factory's assets by a small number of workers. In a labor-intensive factory, the equity per employee is negligible. The equality problem may lead to social or political instability. Management Buyout (MBO) at a low price, or free offering of some shares (say, 5 percent) to management is an attractive idea for many reasons. However, there is a sequencing problem. If an existing economic system does not differentiate between competent management professionals and inherited bureaucrats, MBO might be arbitrary or might become a bureaucratic buyout. The public may react strongly against unfair redistribution. MBO can be a good choice at a point when competent managers can be identified. MBO does not help a lot at the beginning stage of reform; thus, it also cannot help with radical privatization. 130 Reform Sequencing and State Asset Management in China Using Vouchers The voucher type of capital distribution of ownership transformation sounds much better and is more attractive for reformers, including Chinese reform economists. (In 1986-87, the Chinese G2 with some economists of the World Bank proposed a voucher type of ownership reform for China. Actually, the proposal was a corporatization of SOEs and transformation of state ownership into institutional holding, rather than privatization in the GI concept.) The advantage of vouchers over other methods lies in (a) it is fair and allows equal redistribution for the populace, which is especially important in socialist economies with a tradition of equality; (b) it can solve the problem that domestic buyers do not have enough capital in comparison to the total assets prepared for privatization; (c) it can eliminate excessive dependance on employee participation in ownership, which creates the phenomenon of worker autonomy; (d) it encourages people to pay attention to the capital market and corporations they have invested in; and (e) it can promote enthusiasm and social support for privatization, since everyone seems to receive additional assets. However, G2 suggests that the voucher is only a good beginning to the privatization process. Time must be allowed for new owners to play an active and correct role as needed by a market economy. There are two ways to change SOE ownership after vouchers are distributed. The first is to auction SOEs. Except for the capital source, the auction procedure is the same, which includes transforming the accounting system, corporatization, asset evaluation, disclosure, etc. Then potential buyers can scan these SOEs one by one, compare the enterprises, and decide on a price to bid. This process is time-consuming. Probably, before the process proceeds to the transaction stage, a proportion of the vouchers have already been sold at low prices, since some citizens may have cash flow problems. These vouchers may be purchased by professional investors and institutional investors. It is good for privatized SOEs to have professional investors on their boards of directors, but it probably becomes another source of social complaint regarding the acquisition of wealth at unfair prices and unequal cash flow. The second way to change ownership is random assignment, that is, using a computer random-number generator to assign each SOE's equities to some voucher holders at roughly estimated prices. Later on, formal corporatization and evaluation as well as equity transactions can follow. Every investor initially get an arbitrary equity portfolio, but they can restructure the portfolio later on. This proposal can really accelerate the first step of ownership transformation, but still takes about the same time to reach the second stage where owners can really play an active and proper role on the board of directors, based on necessary information and knowledge. The acceleration of the first step is superficial in the whole privatization process. Prior to the second stage but after the random assignments, owners/investors are passive; they find no room and no need to actively participate in the game. They may prefer holding and waiting, or simply selling their equity at an available price. Since the goal of privatization is not only private property, but also an essential mechanism for using property rights privately, the process becomes meaningful only when the new owners can participate actively to replace the old Zhou Xiaochuan 131 state ownership. Therefore, in this sense, accelerating only the first step (distribution of vouchers) is not essential to solving the problem. If we assume that the majority of shareholders need time to acquire knowledge and preliminary experience in dealing with their equity or voucher, and assume that the professional institutions (such as accounting firms, law firms, brokers, consulting firms, exchange house, etc.) need time to be established and their staff need time to be trained, then the process for reaching the stage of the owners playing an active and competent role has to be time-consuming. G1 may argue that the majority of the shareholders need only very limited knowledge and experience. They can rely on professional agencies, and most professional institutions in the capital market can be operated by foreigners. Obviously, it is easy to talk this way, but there is no guarantee that it will be accepted by the public and political figures. There are many approaches to speeding up privatization of small business. Some of them are effective and well known in many economies, including China. Although there are the same problems in fairness of wealth redistribution, the assets are small and local and redistributions are localized. Thus, any unfairness is minor and is unlikely to jeopardize social stability. The difficult problem basically lies in privatization of large- and medium-size SOEs, many of which are capital-intensive. For large-size economies, where there are many large and medium SOEs, as in China, privatization is much more difficult. There might be some other ways or new inventions for quick privatization beyond the above-mentioned observations and comments. They are awaiting evaluation. Anyway, if there is no approach available that can effect fast mass privatization, why should we emphasize the role of privatization so heavily in a reform package, with the high cost of social and political turbulence in the introductory phase? Is that a kind of economist religion or preference? Why can't we propose a rational sequence of reform steps according to the time characteristics and interrelationships of those necessary actions? D. A MINIMUM PACKAGE IN THE INTRODUCTMRY PHASE: EXPERENCE IN CHINA Based on the above-mentioned constraints in socialist economies and the arguments about democratization and privatization, this paper suggests a minimum package that is necessary and manageable for the introductory phase of reform transition, as well as for creating momentum for reform to continue. The minimum package can be summarized as "relatively radical marketization + preliminary political reform + corporatization." Beneficial reform actions, if they are not necessarily needed or coordinated in the introductory phase, can be considered in later phases when a basic framework of the new economic system has been implemented and the consequent efficiency gains have brought new momentum for further reform. This G2 opinion is closely related to the observation and analysis of the reform experience in China, and in Asian newly industrialized economies (NIEs) in the sense of economic liberalization. There are both positive and negative lessons in these experiences: the reform in China is 132 Reform Sequencing and State Asset Management in China basically successful. However, it could have been better or faster in some respects, and there are some unsolved problems awaiting further decisions and actions. When the former Soviet Union strongly pushed democratization, characterized by glasnost, some observers seemed to forget that preliminary democratization happened in China, in contrast with the Soviet Union. They simply described the reform in China as only economic reform without political reform. In fact, around 1978 there was a preliminary, though very important and significant, political reform that brought reform leaders to top decisionmaker positions and changed the political thinking mode. The major actions were: (a) overthrow of the Gang of the Four, including its residuals; (b) strong criticism of the political and economic framework of the Cultural Revolution and some of the later phases of Maoism, especially the traditional dogmatism; (c) establishment of a new Constitution, and much new legislation that followed; (d) resumption and improvement of the democratic system in the Communist Party, the People's Congress and the Chinese People's Political Consultative Conference (CPPCC); (e) liberation and reassignment of a number of Party members with new viewpoints; (f) repeated emphasis of the role of intellectuals; (g) establishment of the new principle of "practice is a unique criterion for testing any theoretical truth"; (h) placement of economic development in the core position; (i) reassessment of the role of the market mechanism and its related concepts; (j) open expression of public opinions; and so on. One of the results of these political reforms was the successful change of leadership and the relative stability of the new leadership where many strong decisions regarding reform could be committed and where a large amount of government energy could focus on reform design as well as implementation. Meanwhile, the extent of democracy was helpful for maintaining strong leadership, since the majority of the people supported reform. This kind of democracy was not in a form of creating competition among political figures, which might make political leaders behave in a much more populist way and focus much less on economic reform. Another important result was that Zhou Xiaochuan 133 private economic rights were preliminarily established by the amended Constitution and the following legislation, as well as policy-making. Progress was based on free discussion of many issues among different schools of thought. This change laid the foundation for market-oriented economic reform. Some observations on NIEs, though not elaborated here, show similar experiences in the relationship between political reform and economic reform. This kind of experience suggests that preliminary political reform is needed. The question of how far and how fast it should go may be subject to trade-off between creating a reform agenda and maintaining government stability to implement reform and manage the transition. Therefore, a reasonable sequencing can be arranged with preliminary political reform at the beginning, followed by strong and effective economic reform, then followed by a larger scope of democratization based on more abundant economic welfare. Marketization, according to experience in China's reform at the introductory stage, is the core of the economic reform package, in the sense of raising economic efficiency in both resource allocation and enterprise operations, as well as creating momentum for reform to continue. In the 1978-92 period of China's reform, the concept of a market economy and marketization have been gradually accepted. Most reform actions have actually been along the lines of marketization. This kind of gradual marketization has its advantages and disadvantages: (a) Reform development has progressed along with a gradual change of viewpoint in both the leadership and the public. A substantial change of viewpoint is needed for reform, highly controversial as it is. After each step of policy change, time was allowed for the public to realize the benefits of that change. Thus, reformers could gain public support against those who continued to support the principles of a CPE. (b) The process of marketization has been relatively slow with some missed opportunities of more effective push in reform and better efficiency. The parallel existence of the CPE and the market economy during the transitional period has inevitably prompted inflation, rent-seeking, corruption and unfair income distribution, which could also jeopardize political and economic stability as well as reform momentum. By analyzing this twofold experience, this paper suggests that marketization in China is necessary, but it could have been faster and better coordinated into a better package. This package includes necessary reforms in the following fields: (a) Price reform, including price decontrol and transitional price adjustments for reducing gaps between market equilibrium prices and existing prices. In some highly distorted fields, one-step price liberalization is too pressing to allow producers to survive and provide employment. Price reform in two or three consecutive steps can be better for allowing producers time to 134 Reform Sequencing and State Asset Management in China restructure. However, price reform should be basically quick and radical, with enough (not excess) pressure on producers to restructure and face worldwide competition. (b) Fiscal reform: (i) A new taxation system must be established to fit in with and support market competition on a level playing field; in the old system, tax revenue used to be highly dependent on SOEs and their artificially high product prices; (ii) The accounting rule must be changed to reflect real costs and profits; (iii) On the budget side, state investment in profitable industries must cease; expenditures should be appropriate to the new functions of government in a market economy; (c) Reform in the banking and nonbanking financial sector: (i) Establish and improve the two-tier banking system, where the central bank will focus on monetary targets and supervision; (ii) Change the Soviet type of specialized banks into commercial banks or universal banks without governmental obligations, and create competition among these banks; (iii) Separate policy lending from commercial lending, to stop direct intervention by government in commercial banking; (iv) Develop a money market and its related instruments; (v) Gradually develop a capital market and its related infrastructure and institutions. Since the process requires a relatively long time to maturity, it needs to be started early in reform; (d) Trade reform: (i) Set the exchange rate at the equilibrium rate or let the rate float according to the market; (ii) Adopt free entry and equal-footing competition policies; (iii) Eliminate import and export subsidies, to diminish quantitative restrictions; Zhou Xiaochuan 135 (iv) Change the Soviet type of trade companies into financially self- sufficient firms; (e) Enterprise reform: (i) Separate management of large and medium companies from their state or collective ownership. Set profit maximization as the objective of management; (ii) Corporatization; (iii) Assign full, independent decision-making power to management; (iv) Change the accounting system in enterprises to fit the market economy; (v) Allow and encourage a plural development of ownership, including private ownership and nonstate public ownership; (f) Reform in the social security system: (i) Establish new institutions responsible for pensions, medical care insurance and unemployment insurance, while withdrawing these functions from the enterprises; (ii) Remove the enterprise responsibility of providing low-rent housing for their employees. Privatize or merchandize the existing housing of enterprises. Diminish the scope of housing subsidies; (iii) Promote labor mobility and better allocation of human resources, while also promoting the new objective of profit maximization by removing enterprises' social responsibilities; (iv) For the sake of social stability, coordinate the creation of a new socialized system with the removal of responsibility for employee security and housing system at the enterprise level; (g) Reforming government functions in economic administration: (i) Except for some transitional administrations, the basic government functions must change from a CPE type to that of a market economy; (ii) Use indirect policy instruments in reaching macroeconomic targets, instead of mandatory orders; 136 Reform Sequencing and State Asset Management in China (iii) Focus on providing public services and public goods as well as maintaining macroeconomic balances, instead of direct intervention in enterprise operations. In the process of the above-mentioned package reform, there are three important items in policy-making: (a) Maintain macroeconomic stability with low and tolerable inflation. Inflation can jeopardize rapid reform or even reverse the process. Reform means restructuring the price system, which has to be inflationary. Additional inflation caused by misleading macroeconomic policies may bring too much trouble to both government and the public for a smooth continuation of the reform process. (b) Maintain or raise the saving ratio in gross domestic product (GDP). Economic growth depends not only on reform but also on savings. The growth rate is usually used as a criterion for testing reform performance. In socialist economies, savings used to be partially forced, with shortages and queuing. Reform can change the shortage phenomenon and saving may decrease. It is important to adopt appropriate policies in interest rates, consumer credit and other related fields to regain a relatively high savings ratio on a voluntary basis. Thus, new investment can help reform performance. (c) Smoothly change the foreign trade pattern to allow time for restructuring the export sector. A sudden radical change (e.g., CMEA trade) goes beyond the capability of export producers and trade companies to adapt. During the transitional process of trade reform, some parallel rules can be allowed, such as free trade with hard currency payment, countertrade, border barter trade and limited state trading in the form of intergovernmental agreements. The purpose of trade is not only to earn hard currency and exchange goods with industrialized economies, but also to realize comparative advantages with the less developed world and to maintain employment. In 1988-91 when reformers in the former Soviet Union and Eastern Europe asked for hard currency payment in trade reform with China, Chinese policymakers agreed to the new payment rule. Meanwhile, the Chinese kept on encouraging countertrade and border barter trade with them, although the hard currency payment is no problem to the Chinese. These points try to show that reform does not imply the sacrifice of other socioeconomic goals in implementing a new mechanism. Careful and practical arrangements, with coordination, sequencing and management of transition, may enhance reform performance and economic welfare that is consistent with the reform goal. The GI opinion seems to say that former socialist economies are not reformable and must be replaced at any cost, no matter how much the cost will be. Zhou Xiaochuan 137 E. RESTRUCTURING EXISTING STATE OwNERSmP Restructuring state ownership, here, means to find a better form for existing public ownership rather than privatizing all publicly owned properties in industry. Restructuring becomes part of a reform package in its later, deeper stages. Since the restructuring of ownership can take several years, restructuring is not a necessary part of the minimum package in the introductory stage of reform and does not contribute substantially to the whole economy at this stage. However, just because the process of creating a better ownership method and a mature capital market takes a long time, it should be started early so that the transition attains a certain stage necessary for moving to the later phase of reform. The overwhelming feeling in today's world is that public ownership is hopeless and incurable; the performance of publicly owned companies is extremely poor, including those in China. Therefore, there is no need to discuss such a topic unless it is about privatization. Then, a careful observation with empirical analysis has to be made for testing this idea and for determining if the topic is still worth elaborating upon. Taking China's case for convenience, the prevailing opinion insists that most economic growth has been contributed by the nonstate sector, especially the private sector and the Sino-foreign joint-venture sector. The export boom has been mostly fueled by the Special Economic Zones (SEZs) and the southern special provinces. Meanwhile, the state sector has suffered serious losses and needs increasingly larger budget subsidies. This paper tries to show, by using only a few data and reasons, that this picture is distorted. During 1976-88 in China, the growth of gross industrial output value 2/ of the state-owned industrial sector was 8.5 percent on average, which was among the best when compared with other world economies. The collective-owned industrial sector, another form of public ownership, recorded an average 19.5 percent growth rate in the same period. The private sector and the foreign direct investment (FDI) sector and others gained much higher growth, but with very small figures in the base year. At the end of 1988, the private sector and the FDI sector and others (under the terms of individuals and others) reached a level of 7.1 percent of total industrial output, while in 1978 their share was negligible. Assuming there was no development of these nonpublic sectors, then the average growth rate of total industrial output would have been 11.0 percent, a bit lower than the actual rate of 11.8 percent. Therefore, the performance improvement of the public sector in reform has been significant, and the contribution of public sector growth to the total growth has been both substantial and dominant in share. The SEZs and southern provinces, usually referring to Guangdong and Fujian, have a relatively higher pace of development of foreign trade. However, they cannot be said to be the only source of the export boom. In 1991, the SEZs' export volume was 7 percent of China's total export volume, Guangdong 17 percent (excluding 2/ According to the definition and data source of The Statistical Yearbook of China, 1992, pp. 406-407. 138 Reform Sequencing and State Asset Management in China Shenzhen), Fujian 4.6 percent.3/ The remaining export volume was dispersed among many provinces. The inner provinces can also develop trade at a fairly fast pace. For example, during 1985-91 all the inner provinces attained an average 18.4 percent growth rate of exports, higher than the national export growth rate of 15.3 percent on average during this period.4/ These data do not include those goods produced in these inner provinces but exported through coastal trade firms. In addition, private and collective firms were not allowed to participate in foreign trade business until 1991, other than supplying some exportable goods for the state-owned trade firms. In China, SOEs account for a very large share in sectors producing capital goods and input materials. They account for a relatively small share in sectors producing consumer goods, partly because of policies for new entry and partly because of the historical heavy-industry bias. During the anti-inflation period of 1989-91, the government relied too much on restricting fixed-asset investment for reducing aggregate demand. Thus, total fixed-asset investment 5/ in 1989 fell to 78.1 percent of that in 1988, and in 1990 investment was 82.3 percent of that in 1988, deflated roughly by the retail price index.6/ This kind of demand restraint mainly hurt SOEs. Thus, many observers could see the problems of SOEs when comparing them with other forms of ownership. The result of the anti-inflation period was that one third of the SOEs suffered losses and took state subsidies, one third broke even (or with marginal losses), and only another one third made a profit. However, it is not a strange thing in a market economy where competition can bring down the profit level on average, especially in a recession. In addition, SOEs in China have enough motivation to break even with negotiable profit targets and a 55 percent profit tax, plus many additional tax charges. Meanwhile, total budget subsidies for SOEs were only 2.5 percent of GDP (Y 51.024 billion in 1991).2/ Around one fourth of the subsidies were for the energy sector, which supplies energy at low state-fixed prices, and around one fourth were for sectors supplying other basic needs at low state- fixed prices. These subsidies should be removed during the reform process, but they do not sufficiently prove that SOEs are incapable of reform. In many market economies, social welfare programs are usually channeled directly to subsidize some households through the budget or tax deductions. The amount of such kinds of transfer payment is usually high. In China's case, this payment is part of SOE losses. In the second half of 1991, capital investment started to pick up; thus, SOE losses began to reduce. The forthcoming 1992 statistical data will be able to further support this proposition. 3/ The Almanac of Foreign Economic Relations and Trade of China, 1992, pp. 54-55. 4/ Source for 1985 data: The Almanac ofForeign Economic Relations and Trade of China, 1987, p. 329. 5/ The Statistical Yearbook of China, 1992, pp. 145. 6/ The Statistic Yearbook of China, 1992, pp. 237; the price index for capital goods was not available. 7/ The Statistical Yearbook of China, 1992, p. 218. Zhou Xiaochuan 139 In comparison with Western statistics, the data reflecting the potential of Chinese SOEs have overreporting and underreporting factors. Some underestimating factors are scarcely noticed; they are listed as focus for attention: (a) For evading heavy taxes and gaining more flexibility, many SOEs create new establishments in the form of collectively owned enterprises or others. They are, in name, independent, but are virtually full subsidiaries of those SOEs. The SOEs transfer a substantial part of their added value and profit to these establishments through "inner" transactions. (b) When an SOE finds a foreign investor or partner to form a new joint- venture or cooperative-venture entity, the SOE's total production value and its assets and growth shift into the FDI sector category; thus, it contributes purely negative figures to the SOE statistics. The open-door policy has been providing many incentives to SOEs for absorbing foreign capital and/or technology in these forms. SOEs are also enthusiastic about joint ventures with fictional "foreign" investors. (c) Some of the SOEs supply public goods or meet some basic needs at low prices set by the government. This kind of SOE should be excluded when comparing enterprises with other forms of ownership. (d) Some social welfare responsibilities are assigned to SOEs according to the CPE tradition. Thus, SOEs are not profit makers like enterprises with other forms of ownership. For tax reasons, SOEs have a strong motivation to attribute expenditures of these responsibilities to production cost. (e) SOEs have a much heavier tax burden. In 1987, they contributed 75 percent of total fiscal revenues. The collective-owned enterprises provided 18.4 percent.8/ SOEs have a lower depreciation allowance under the out-of-date accounting rules. SOEs are also restricted in decision- making powers regarding business scope, pricing and employment. These factors underestimate the potential of SOEs and are also institutional weaknesses that must be reformed, and can be reformed. The purpose of citing these factors is by no means to defend SOEs, but to promote the view that restructuring (not full privatization) of SOEs is still a topic worth examination. For reforming SOEs in the introductory phase, this paper emphasizes marketization and corporatization as mentioned previously. Restructuring ownership of SOEs should start early since it will take many years. In the G2 design, the task is to find a better substitute form-institutional holders/investors-for carrying the responsibility of public ownership, and to avoid, in the introductory phase, the sensitive redistribution of public assets. 8/ The Statistical Yearbook of China, 1992. 140 Reform Sequencing and State Asset Management in China Before briefly describing this design, some explanations of ownership-related concepts are listed here. (a) Market transactions should be based on clear property rights or clear principal-agency relationships. Since the concept of owner of SOEs is far from enterprises in socialist economies, the principal-agency relationship should be utilized to the maximum. (b) For a listed large-size company in a market economy with many shareholders, the board of directors can be an agency of shareholders. Its directors can be professionals and other responsible agents, not necessarily shareholders. But the general meeting of shareholders has final power of selecting those agents on the board. (c) There must be a competitive environment in the product, capital and manager markets, where the principal can make a fair evaluation of agent performance, as well as selection of agents. (d) The form of a stock-sharing company with separation between management and ownership is widely accepted for large-size firms. This form defines clear ownership and provides checks and balances. (e) A holding company or investment management company is not able to supervise an unlimited number of subsidiaries because of limited information capability and organizational limit. A manageable number may be between 10 and 30. (f) For holding companies as institutional owners, there must be clear final ownership. The explanations also imply a diagnostic tool for China's ownership reform. The G2 design of the new structure of public ownership for China's reform is briefly illustrated in Figure 1. Where Ci (i=l,n) are holding and investment companies; C, (j=1,m) are holding and investment subsidiaries of Cj; Eijk (k=1,K) are industrial enterprises owned by Cj, shifted from SOEs; n,m and K are manageable numbers from 10 to 30. Downward and horizontal cross-holding or joint holding are allowed; 103 to 30' SOEs can be transformed into this structure with active owners. C, and Cj as well as large-size Eik are listed on the stock exchange with disclosures; thus they compete with each other and are evaluated by the market; then owners and boards can acquire more information about relative performance. The Public Ownership Commission, elected by the Congress Standing Committee, is the final board representing public ownership and is responsible for assigning board directors in C, (i=l,n) based on professional competence and C1 performance. The commission's decisions, votes and all speeches are publicly reported; thus the electorate can watch over each commission member. All directors sitting on the boards of Ci and Cij are competent agents hierarchically selected and well Zhou Xiaochuan 141 Figure 1: OWNERSHIP RESTRUCTURING Population with Election Right Congress and its Standing Committee The Public Ownership Commission under the Standing Committee Holding C, Holding C2 ... Holding C. FI I C1.1 C1.2 ** C1.u C2.1 02.2 ... C.1 C 2 * .. EJJk . .. EiJ . .. EiJk . .. EiJk paid by the upper level. In Ci, Cj and Eij, management and ownership are separated in a checks-and-balances framework. Since the original SOEs are widely undercapitalized with a high debt-equity ratio, Ej usually do not distribute dividends to Cj and other shareholders until they are recapitalized, while C, and Ci operate with the objective of equity maximization. Ci do not distribute dividends to the Commission or the Committee. The Congress and government expenditures depend fully on the fiscal budget. Some independent consultant firms, law firms, accounting firms and the stock exchange as well as the manager/director market play active roles to serve this structure. Every movement of every director is watched and checked/balanced by someone else. The government, used to playing policymaker, owner and management interventionist of SOEs in a 3-in-1 mode, now focuses only on policy and rule-making while creating a level playing field. Some of the local structures, similar to the Figure 1, would be permitted for the transformation of local medium-size SOEs. Then, nationally and locally, parallel efforts may accelerate the transformation process. Now we come to the question of how to move into this structure. Chinese G2 used a term of "virtual capital" given by the Congress to the Ci (i=l,n) for buying SOEs. It was similar to vouchers; thus we use the word voucher in the following description. The Commission issues an number of vouchers to be equally invested into C, (i=l,n); Ci can be selected from existing large banks and investment companies, or newly established holding and investment companies. Now C, (i=l,n) are owned or partly owned by the Commission representing the general population. C, use acquired vouchers to invest 142 Reform Sequencing and State Asset Management in China and form Ci (j =1,m). Along with SOEs' corporatization, selected SOEs are going to be sold sequentially on the capital market, where Cj can use their vouchers to buy shares and citizens can also buy shares with real money. An optimistic estimation of this process with some parallel operations is no less than five years for the large size of the economy of China. However, the new owners are active and well informed from the beginning. The state does not really sell the state assets of SOEs, since the Commission owns Ci (i=l,n) and on the balance sheet of a Ci, the equity of E (j =1,m; k=1,K) is aggregated via Ci (j =1,m). Therefore, there is no problem of redistributing public wealth. The transition development process is also a process in which the stock exchange, its auxiliaries and the manager market can gradually grow with and become more experienced. Since large banks are involved in forming Ci, debt-equity swaps can be made for seriously undercapitalized E1,, together with ownership transformations. Initially, the Commission may allow all C, to spend 1 percent of the given vouchers to buy or exchange office buildings and facilities, so do Ci for C,. The new structure of public ownership and its transition imply that many existing industrial ministries and their local subordinates are eliminated, many government office buildings are for sale, and a number of employees in these ministries may become candidates for Ci and C,1 seeking competent persons in different positions. C take a fixed small percentage of Eijk (k=1,K) equity value from the E, cost account for covering C daily operations; so do Ci from C,1. Ci and C,1 are subject to capital gains tax. Generally, wages and rewards are downward paid or decided. The commission pays all C, directors; each Ci board decides the wages of Ci management, paying from the Ci operating cost account; Ci management pays C, (j =1,m) directors the Ci operating cost account; each C board decides the wages of C,1 management, paying from the C operating cost account; C4 management pays EW (k=1,K) directors from the Cg operating cost account; each EiA board decides the wages of E, management, paying from the E, operating cost account; EiA management pays its employees from the Efi operating cost account. Since the management goals in most cases are equity maximization, share options are also used as a part of the incentive system in this framework. One of the serious problems of SOEs in China is an excessive burden of social security responsibilities, mainly paying pensions, health and medical care, unemployment compensation and providing low-rent housing for their active and retired employees. Market-oriented reform must take these responsibilities away from the SOEs and enforce the goal of profitlequity maximization. In the designed structure, Ci will establish a pension fund, a health insurance fund and a real estate department for assuming these functions. In the transformation process when Cj bid to buy Ei, Cj estimates, not only statically but also dynamically, the burden of pensions, health care, surplus employees and their resources for those functions, such as EA-owned housing and other social security facilities, of each specific E . Then Ci put all rearrangement considerations into its bid price. When the ownership of E transferred into the hands of C,, the existing accumulated security-interest claims of EiA employees are transferred, via C1, to those functioning bodies in C,. After this, the EiA employees will be paid at real wages and they are capable of paying market rents for housing or a mortgage, contributing monthly to the pension fund and medical insurance, paying a payroll tax for basic social security, if Zhou Xiaochuan 143 established. Hereafter, Eu employees are not confined to concerned Ci function bodies, but can choose among pension funds and health insurance funds based on their observations of competitive service, prudence and equity gain. Ci can also sell or buy their resources and liabilities in this respect for forming a better specialization of these functions. An additional advantage of this transformation is that more people will watch closely the performance of Ci for the sake of their pension and so forth; it can help the Commission considerably and improve allocative efficiency of social security funds. The process can go parallel with the employee share-participation program and management performance bonus in share options in some EA with a limited percentage of Ep, total equity. The process is mainly for large- or medium-size SOEs, while small SOEs can go parallel or faster for privatization. Joint-venture EA held by Cj and foreign investors are also encouraged. In the later phases of this transformation, Ci and Cij can use other financial instruments, such as mutual funds, corporate bonds, etc., to perform the investment function. The EA board can decide to distribute dividends to Cj for investment in other profitable business fields. The joint holding situations, e.g., equities of an EW held by several Cj with different i, do not dissolve the above-mentioned transformation framework. However, for simplicity and convenience of conceptualizing, only the hierarchical case is illustrated in Figure 1. F. SummARY In the introductory phase of reforming socialist economies, the minimum package, suggested in this paper, can be smaller than the troika. This package contains preliminary political reform, relatively quick marketization and corporatization, with an early start to restructuring SOEs. China's reform basically follows this kind of package. However, the marketization has not been as quick as is possible, while missing some opportunities and creating some problems, such as: (a) A fiscal deficit and a deficit in the balance of payments happened, which led to economic instability and reform cycles. These are directly related to the coexistence of CPE and market rules in both microeconomic activities and macroeconomic management. (b) Corruption has been growing quickly in administration. The transitional status of the economy has been providing many rent-seeking and rent-setting opportunities. (c) Unfair income distribution happens, mainly because of unequal competition and rent-seeking. (d) Efficiency gains in resource allocation have not been satisfactory. 144 Reform Sequencing and State Asset Management in China As another problem in China's reform, a consensus about the way to restructure SOE ownership has not yet been reached, although the necessity of doing so is now widely recognized. Therefore, this paper reemphasizes its opinion about this issue. Government-led reform in sequencing, if possible, is highly recommended rather than a maximum frontier in all reforms. The considerations for sequencing are (a) a logical and coordinating relationship of reforms; (b) keeping momentum for reform continuing (relating to measuring marginal economic utility and political utility in different situations); and (c) management capability in reform transition. The suggested sequencing is that preliminary political reform goes first, quick marketization follows, then a large- scale transformation of SOE ownership follows. Democratization and human rights will certainly develop along with this process, based on shifting of public choice. In marketization, the reform actions that can bring efficiency and benefit quickly, such as an incentive mechanism, price decontrol in consumer goods, etc., should be arranged early. The actions that may partly reduce social welfare or security should be arranged together with some benefit-gaining actions. The choice of gradualism or radicalism depends on economic conditions, especially on situations of crisis; administrators usually favor a gradual reform. Thus, the reform must start early when the crisis has not yet become serious; otherwise there is no room for a subjective choice. Economics should not be a specific kind of belief or value. Economists have to continuously seek truth in an evolving world. This paper suggests that fast privatization may not be the unique, effective approach for reforming socialist economies. There might be another solution for restructuring SOE ownership. Study of economic development and reform alternatives does help to gain more empirical knowledge in economics and should be welcome. Economics also provides some skill for economic problem-solving, including problems for transitional circumstances with a specific set of constraints. The task for economists is to try to solve problems, instead of passing judgment very early on. Peter Harrold on Zhou Xiaochuan 145 COMMENTS ON "REFORM SEQUENCING AND STATE ASSET MANAGEMENT IN CHINA" by ZHOU XIAOCHUAN Peter Harrold 1/ A. INTRODUCTION The paper by Zhou Xiaochuan makes a typically convincing case for the Chinese approach to economic reform. While the case is made that reform of state ownership of enterprises can come late in the reform, I believe it is clear that the Chinese reform has progressed to the stage when this now has to be addressed seriously and with some urgency. He argues, and I agree with him very strongly, that privatization can take a long time, and that marketization and corporatization are therefore the priority steps. It is also the case in China that we must design actions within a political imperative that maintains socialism, which I interpret to imply the maintenance of a wide range of public ownership. I will also take as a background assumption a broad agreement on the need to socialize the provision of pensions, housing, health and education, so we need not dwell on those barriers to action in the area of state enterprises. I am also of the view that past reforms have gone a long way toward achieving marketization, so I consider the main challenge in this area to be that of corporatization, which is where I will focus my comments. As Zhou Xiaochuan's paper makes clear, most state assets in China are in the state-owned enterprises. As such, any reform of the state asset management system must be concerned primarily with the relationship between the state and enterprises. It is broadly accepted that enterprise reform lies at the heart of the reform effort in China, and that, while many other reforms are complementary and crucial, they will all fail if enterprises are not made sufficiently responsive through reforms. It is clear that for many firms major restructuring will be needed to achieve viability and efficiency. Greater distance needs to be put between public administration and enterprise management, so that the latter may be held accountable against hardened budget constraints. For us, it is these issues of enterprise reform that define a state assets policy. This paper notes some options for China in this regard. In particular, we begin by seeing whether we have reached the stage in the reform process, as described in Zhou Xiaochuan's paper when these reforms need to be addressed seriously. What is the SOE problem? The essence of the SOE problem in China is that it has a large number of inefficient, badly structured and poorly run enterprises. These enterprises are now running large losses, which have to be covered either by the budget, or via directed credit from the banking system, and this has clear implications both for macroeconomic stability and for the efficiency of resource allocation. China's very high savings performance in recent years has made the carrying of such losses possible in 1/ Peter Harrold is Principal Economist, Country Operations Division, China and Mongolia Department, The World Bank. 146 Comment the short to medium term, but, clearly, the long-term impact on banks' portfolios and on the government's discretionary expenditure capacity would make such a burden unsustainable. In this regard, China's problems with its public sector are very similar to those experienced in a wide range of countries. The origins of these problems lie in two areas. First, these enterprises were established during the period of strong central planning in China. This means that they were created under administrative fiat, and thus often suffer from poor decisions with respect to location, size, product mix, technology and capital/labor mix. These enterprises are candidates for extensive restructuring. The second set of origins of these problems is the system under which these enterprises have been and continue to operate, with respect both to the broad policy framework, as well as the relationship between these enterprises and the state as their owner. This second set of issues in particular has led to poor management practices. How big is the problem? During the last six years, the level of losses of the SOEs within the state budget 2/ has been in the range of 3.7 to 5.3 percent of GDP. On average, 72 percent of these losses have been covered by the budget, and every year, the size of the subsidy has exceeded the size of the budget deficit. The balance has been provided by bank credit provided on a policy basis. Provision of such credit has priority in credit allocation decisions, and, in times of austerity and tight credit, this has served to squeeze out the nonstate sector from access to credit. Thus, to the extent that China has a fiscal problem, this can be more than accounted for by the need to subsidize these SOEs. Of the total SOE losses, four categories explain 99 percent of the total: industrial enterprises (39 percent); grain (32 percent); foreign trade, mainly imports (19 percent); and other commerce (9 percent). Within the industrial losses, coal explains 21 percent, and crude oil a further 14 percent (i.e., these two sectors explain 13 percent of the total). Thus, a significant percentage of the overall losses can be explained as a set of "policy losses," which are susceptible to change through reform of prices and distribution systems.3/ The presence of these policy losses makes it very difficult, however, to judge the level of efficiency of these enterprises. It is undoubtedly the case that corporatization of SOEs has become an urgent priority, and there are several reasons for this. Experience elsewhere, now being repeated in China, has shown that relaxation of state control and oversight-which is critical for efficiency gains-and decentralization of power to enterprise management will, in the absence of ownership reform, have undesirable consequences. The most important of these are the "spontaneous privatization" of enterprises, and the stripping of state assets by management. There are many examples of this occurring already in China: 2/ These are the major state-owned enterprises owned at the national level, whose tax payments are direct to the central government, and whose profit remittances are made to the Ministry of Finance. 3/ "Policy losses" derive primarily from selling prices being fixed below cost for, e.g., coal, oil and grain, and, in trade, particularly from mandatory imports of commodities with low fixed domestic prices, such as timber and wool. This said, elimination of these losses may not in all cases have a positive impact on the budget, as the raising of these prices would have a negative impact on downstream industries, some of which, such as petrochemicals, are at present very profitable and high taxpayers. Peter Harrold on Zhou Xiaochuan 147 * the growth of wages and nonwage benefits, especially in loss-making enterprises, at rates well in excess of either productivity gains or inflation; * the related reduction in declared profitability, and of payments to the real owners, the state; * as Zhou Xiaochuan mentioned, the diversion of high-profit lines of activity to low-taxed subsidiaries such as collectives or joint ventures. Two points should be noted here.4/ First, the share of the SOEs in total industrial output has fallen sharply over this period, from 78 percent in 1978 to about 50 percent now. In some sectors, such as light manufacturing (toys, footwear) and garments, the nonstate share now greatly exceeds the state share; in other sectors, however, such as steel, energy production, transport and fertilizers, the state share remains very high, and has changed little over the decade, implying that the "SOE problem" is unlikely to "wither away" if left to itself. Second, the growth of losses over this period is also a reflection of the success of the reform program in generating competition, for it reflects in part the elimination of supernormal profits, especially in light industry, as new entrants have emerged and competed away profits, frequently driving the badly equipped, located and managed SOEs into loss-maldng. The limits to action in China. Many SOEs in China are probably bankrupt, and in a market economy they would either exit, or be taken over and drastically restructured. China, like many other developing countries, is not prepared to face the political and social consequences of widespread enterprise failure and the related unemployment. It will take time to develop the new social systems to replace the present provision of housing, pension, health and education benefits through enterprises, and to generate the alternative sources of employment opportunity that will be necessary before large levels of excess labor can be shed from the SOEs. Moreover, we should recognize part of the reason for this: China has opted to retain a socialist political system, which requires a significant role for the state in the ownership of productive assets. It is therefore clear that neither wholesale bankruptcy nor privatization is going to occur, at least so long as the very strong savings mobilization effort continues to make the carrying of such deficits practical. But China has also demonstrated time and again that it is willing to act pragmatically in the interests of economic development, as witnessed in the way it has encouraged the dramatic growth of the nonstate sector over the last decade.l/ Therefore, China will adopt those measures that will assist in improving efficiency, and this would include changes in ownership of SOEs, as well as changes in management systems. In this respect, privatization can be expected to provide one instrument that China will use to stimulate economic gains, but it would not be politically acceptable, as 4/ In should also be noted, however, that despite these losses and inefficiencies, the SOEs have turned in a very respectable growth performance in recent years, registering 8.5 percent per annum output growth over the 1980s, and registering an estimated 2.4 percent average annual improvement in productivity. I/ The report of the 14th Party Congress noted that "We must not get bogged down in an abstract debate over what is capitalist and what is socialist." 148 Comment noted, to push for wholesale privatization, or for the elimination of the bulk of the SOE sector as a policy aim. Thus, our yardstick for assessment in China should be the necessary reforms to induce efficiency gains in the SOEs, and make enterprises behave and react in similar ways to private industry in other countries, rather than any abstract notion of which form of ownership is necessary for efficiency. The rest of this paper assesses the policy framework that we would consider appropriate for industrial SOEs in China. Such a framework needs to be seen on two levels: * macroeconomic policy issues and other aspects of the enterprise environment that need to be addressed to make SOE reforms effective; * the policy framework at the enterprise level to be pursued, and the instruments to do so. B. THE BROAD PoLicY FRAMEWORK Reforms are needed both in the organizational arrangements for public enterprises, and in the policy environment in which they operate. Both are necessary but neither is sufficient. A poor policy framework will encourage equally inefficient public and private enterprises, while state-owned enterprises will seldom take advantage of a profit-maximizing market environment in the face of excessive social objectives, government intervention, poor management incentives, and absence of the threat of bankruptcy. Therefore, what we need to see is parallel progress in the policy framework and in the SOE system. There has been remarkable and well-recorded progress in the broad policy framework in China during the course of 14 years of reform. This was reviewed in depth in the World Bank's most recent Country Economic Memorandum./ Overall, we would judge that the broad policy framework is much less of a concern than it was in the past and should not be seen as a binding constraint to enterprise reform actions, at least in the sense that SOEs can now be regarded as profit centers, and be judged primarily on profitability. That said, within this improved overall picture, there are three areas that continue to give cause for concern, for in these areas it is not yet clear that China is moving with sufficient speed towards a "level playing field." As these are discussed in depth in other papers, they are just noted here. (a) Financial Sector. The financial sector is generally considered to have seen less progress than other reform areas, and this is now recognized by the government. Such progress is necessary both to generate a stable macroeconomic situation and to encourage savings mobilization-which is critical, given the large investment demands for restructuring-but also to contribute more to the enterprise regulation framework. Banks should be 6/ "China: Reform and the Role of the Plan in the 1990s": Report No. 10199-CHA, June 19, 1992. Peter Harrold on Zhou Xiaochuan 149 better able than government to allocate resources between enterprises based on economic grounds only, and they should in time be able to exercise discipline on enterprises in order to safeguard their own interests. The Chinese banking system remains monopolistic and underdeveloped, and banks are still subject to heavy direction. Further, monetary policy is effectively carried out by direct controls. (b) Trade. Most external policies continue to focus on export development and the encouragement of foreign direct investment, with relatively less attention to the import regime. However, recent bilateral trade pressures and the desire on China's part to resume its seat in GATT are forcing a positive reexamination of the import regime, with a clear impetus towards removal of administrative instruments of control. Import reform is increasingly key to additional efficiency gains and for managing the country's foreign exchange reserves and monetary policy. (c) Social Sector Reforms. The direction of social reforms is to separate the provision of services from the enterprise, so that such benefits become "portable," and not a barrier to enterprise reform and restructuring, or to labor mobility, at least between enterprises in the same province. They will also facilitate exit of some bankrupt enterprises. However, although the proposed reforms are sensible, the present timetable (10 years) is far too extended, and unless accelerated, this could continue to be a significant barrier to further reform efforts. Earlier, we noted the overall good performance of China in improving the policy framework, and the generally sound proposals for future reform in a number of areas. This said, while intentions are good, there remains plenty to be done, even in those areas where we did not observe general problems. For example, price reform has made remarkable progress in the last three years, and the overall reform intentions are appropriate, but in certain sectors, such as energy, the present price structure remains distorted and in need of correction as soon as possible. There are several areas that seem to merit particular attention: (a) Competition. The assurance that there is a reasonable degree of competition in the sector or area comes from a number of factors. Most important will be abolition (or nonexistence) of monopoly powers for state- owned enterprises or foreign trade corporations, and a high level of price determination by the market and acceptable timetable for removal of any remaining price controls or allocation by the plan. In addition, price competition can only be fair if state subsidies are absent or being removed. Finally, the government needs to ensure that there are no restrictions on interprovincial trade in goods, and that the framework for external trade is reasonable. This means that enterprises should have reasonable rights to export directly (as opposed to through foreign trade corporations), that the import regime does not offer excessive protection. 150 Comment (b) Entry. While the government has been very active in encouraging both the development of nonstate enterprises and the formation of joint ventures, this has often been only to the extent that such new enterprises did not generate close competition with existing SOEs. While economies of scale may offer considerable barriers to entry in some areas, it is important for the government to ensure that these were not compounded by administrative measures. Guarding against such practices is one of the new roles of government in the market economy. (c) Factor Mobility. Factor markets have been slow to develop in China for a number of reasons, but progress is beginning to be seen, and needs to be encouraged in two aspects. Government should pursue elimination of any restrictions on movements of capital either into or out of provinces; second, while labor mobility between administrative regions is likely to continue to be restricted for a long time to come for reasons of social policy, there could be progress in labor mobility between enterprises in one city or province. (d) Tax Policies. Finally, there are still many anomalies in the current tax policy framework, with different tax rates and assessment systems applying to different enterprises within the same sector or region. In many cases, paradoxically, tax policies act against SOEs. These are presently under review and discussed in other papers. C. ENTERPRISE PoLIcY FRAMEWORK Given its centrality to the overall reform effort, enterprise reform has been continually debated over the last 14 years. Zhou Xiaochuan's paper focuses on one particular approach to the problem, that of the ownership function of government. For our purposes, there are five aspects to consider: the legal framework within which enterprises operate; the systems and regulations governing relations between government and enterprises; ownership reform issues, with respect to both the government ownership function and ownership diversification; restructuring and enterprise development issues; and development of private enterprise, or, more generally in the Chinese context, the nonstate sector. The Legal Framework If the Chinese economy is to move successfully from one in which administrative management and negotiation are the norm, to one in which arm's length trading in a market framework is the standard, the scope and function of the legal system has to develop in two respects. First, an appropriate set of laws and regulations has to be developed, and second, economic agents must have sufficient confidence in, and be able to rely upon legal institutions and procedures, such that these can function effectively. Good progress has been made in China's legal framework for enterprises, especially in Peter Harrold on Zhou Xiaochuan 151 1992 with the passage of regulations governing shareholding and the operations of the SOEs. However, there remain several shortcomings that deserve attention, including: (a) Company Law. No national company law exists, and providing a clear, legally binding set of rules for all types of companies, regardless of ownership, would facilitate corporatization; (b) Other Corporate Forms. None of the existing laws or regulations clarify the status of enterprise groups or of holding companies, corporate forms that are viewed as key elements of enterprise reform; (c) Nonstate Enterprises. As laws governing enterprises are developed further, including, for example, the Bankruptcy Law, they should be extended to cover all enterprises regardless of ownership; (d) Competition Law. One key element of future market regulation should be the development of a competition law, and an appropriate institutional system to oversee the operation of such a law; (e) Clarification of Government Role. New organization of government functions in a market economy will require a legal basis, including its role and actions as owner. Legal and structural definition of "relevant government departments" is essential, as is reduction of the number of approvals needed from such departments; (g) Noncommercial Objectives. The SOE Regulations require enterprises to safeguard "the interest of the state and the public interest." As owner, the state may of course provide for these aims to apply to SOEs, but this should not be confused with the legal framework for all enterprises, as this now serves to create a window for continued administrative interference, and besides, the SOEs should not be burdened by this objective without a clear provision being made for this in the budget. Governance The New Operating Mechanism (NOM) 1/ and its subsequent procedures are the centerpiece of China's new governance policy, and we look forward to its full implementation. This is a major step forward, in that these regulations go much further than any previous document in defining the limits of government power, and the scope for enterprises' own decision-making. Moreover, they grant most economic decisions to the enterprises-in pricing, production, hiring/firing, etc. -while retaining for government, as owner, the right to decide on major investments and on acquisition or disposal of large assets or mergers. However, the NOM fails to address three key issues: the government oversight function; the corporate form for the SOEs; and ownership issues, both with respect to the government ownership function, and ownership diversification. The government oversight function has in the past been exercised largely by the industrial bureaus, the specialized ministries that not only oversee branches of industry, but also exercise ownership rights and issue regulations. These bureaus have been at the heart of the problems of interference and consequent reduced accountability of SOEs. There is now a unique opportunity for the government to address this issue, as the 14th Congress endorsed a proposal to move forward with a major government reorganization, 7/ Formally, the 'Regulations on Transforming the Management Mechanism of State-Owned Industrial Enterprises," published on July 25, 1992. 152 Comment "in accordance with the principle of separating the administration of the government from the management of the enterprises. "8/ The reorganization as it proceeds could consider a much more radical restructuring of the organization of the government's industrial apparatus than has been announced so far, including line ministries and bureaus. The enterprise oversight function could be transferred to other agencies. If this were done, the case for specialized ministries-which are in general a product of planning-would be considerably weakened. There is thus a strong case for the abolition of industrial bureaus, with the transfer of their staff to institutions and organizations (including new service industries) that will play a supporting role to enterprises. This would also require new government ownership institutions, discussed below. Many enterprises in China that are state-owned are purely productive enterprises, and policy towards these is discussed in the following section. It appears to be these enterprises that are the main target of the scheme proposed in Zhou Xiaochuan's paper. However, for enterprises that will long be public enterprises, a central enterprise organization, with a small, highly qualified staff, might be appropriate to exercise the oversight function, and there are successful examples of such organizations elsewhere, such as those of Pakistan and Brazil. For such enterprises, the use of performance contracts is a widely accepted system that has many attractions and should be continued, which raises the issues of the reform of the current Contract Responsibility System (CRS), and of its links to tax reform. As the separation of taxes and profits continues, it is intended by the government that such contracts would be on an after-tax basis (with loans repaid after tax), and that the income tax rate for all enterprises would be 33 percent, instead of the present range from 55 percent down to zero. This should be strongly supported. In doing so, the CRS would be "refined" and "perfected." However, Chinese officials sometimes seem to believe that "refining" the contracts means making them even more complex, with sophisticated ratings systems for technological improvements and productivity gains. Rather, the progress of increasing competition should make such contracts increasingly simple, and focused on profits targets, with clearly spelled out rewards for management for achieving targets. The second issue that is not addressed in the regulations is corporate form. The government's recently published "views" on limited share corporations-which include the mandatory creation of Boards of Directors-provide a good framework for corporatization in a wide range of sectors,9/ but it is not clear how large a number of enterprises this will apply to in the near future. For all other enterprises, the link remains 8/ Work report of the 13th Central Committee to the 14th CCP, October 12, 1992, p. 36. 9/ Pilot experiments in shareholding companies are forbidden for industries in defense and state security, can be conducted in monopoly sectors such as transport and energy, and are encouraged in strongly competitive industries complying with state industrial policy. Peter Harrold on Zhou Xiaochuan 153 direct between the factory director and government.10/ While this may seem attractive to government in terms of identifying one person to hold accountable for failure, it is not conducive to the establishment of appropriate government-enterprise relations, and we would strongly recommend that corporatization of most enterprises under the present or revised regulations should be the standard. A key element of this would be greater reliance on the role of boards of directors, and therefore guidelines should be developed for the nomination and selection of such boards. A key factor will be to mandate terms for directors, and to limit government employees, even though, obviously, government will, at least initially, appoint the board. Banks, pension funds, unions, holding companies, and other industrialists are candidates. Ownership Reform The ownership reform policy of the government has two elements. First, the government is "tolerant" of a multiplicity of ownership forms in the economy, and this "toleration" has recently been made even more flexible by the redefinition of the public sector in the context of the decisions made at the 14th Congress. This defined the public sector to include not only enterprises "owned by the whole people," but also enterprises owned by collectives, with the private sector defined only as individually owned and foreign-owned enterprises. 11/ This means, in terms of this definition, that about 90 percent of all output is from the public sector, even though only 53 percent is state-owned, as opposed to collective. Since much of the nonstate, collective sector can be regarded as quasi-private, at least in the sense that such enterprises succeed or fail according to market principles and distribute their profits direct to their shareholders, this definition gives enormous scope for alternative ownership forms that retain the definitional status required to be classified as "public" within China's new socialist framework. The second element of policy relates to the carrying out of the government's ownership function. In addition to line ministries and industrial bureaus, the main "owner representatives" at the moment are the National Administrative Bureau of State-Owned Property (NABSOP), and the State Investment Corporations (SICs). The difficulty that we have seen in China is exactly the same as that observed elsewhere: that such agencies behave much more like government agencies than financial or business organizations. Thus, we have observed that NABSOP has so far focused nearly all its efforts on counting the value of state assets according to historical investment costs, rather than on assessing and improving enterprise performance; and that the SICs have tended to act basically as a bureaucratic layer for the approval of investment projects initiated by lower levels. This is not surprising, as these agencies have been staffed from within other government departments, such as the State Planning Commission and the Ministry of Finance. It may be possible that these present institutions can evolve, either, in the case of NABSOP, 10/ By the end of 1991, 3,220 enterprises were in the joint-stock experiment, of which 80 percent were collectives, and only 2 percent had issued shares to the public. By the end of June 1992, an additional 363 enterprises had converted to this form, of which 34 had listed on the Shanghai and Shenzhen stock exchanges. L1/ Op. cit., p. 22. 154 Comment towards the sort of oversight institution described earlier, or, in the case of the SICs, towards holding companies or investment banks. For ordinary production enterprises, we have already recommended corporatization as the standard enterprise structure. Zhou Xiaochuan's paper recommends a relatively complex holding company structure, reporting to the National People's Congress. Whatever else we may say about his suggestions, he has one very powerful insight that we should retain in any outcome: for effective oversight, the number of enterprises or other holding companies that one holding company should oversee should be limited: his suggestion of 20-30 seems about right, and many more than this would result in loose supervision. We already discussed at length in the case of the financial sector what can happen when supervision is too loose. We should add to this principle a second: that while diversification of ownership is highly desirable, it should not become excessively dispersed, for then owners are unable to effectively control managers, as we are learning from recent US experience in particular. Let me offer four particular comments on the scheme proposed in Zhou Xiaochuan's paper. First with respect to dividends, an important function of owners is to appoint management and give it profitability targets, and then decide upon the distribution of profits between dividend and reinvestment. For some SOEs, it would be appropriate to use earnings to recapitalize them, but this should not be a general rule, and the principle of the owner receiving a return on assets should be established early; so the suggestion of not paying dividends at first should be rethought. Second, as concerns voucher systems, this suggestion has parallels in such countries as the Czech Republic and Mongolia. I remain to be convinced that it is necessary in China to go through such an elaborate system, and I am not clear what is meant by the idea of "buying" enterprises with such vouchers. Rather, a more straightforward system of external valuation and vesting of shares in the new ownership institutions would seem to offer a more expeditious approach. Third, while the holding company "pyramid" is one approach, there are several options, and this is something that deserves experimentation on a broad front. Among these are the following: (a) The creation of portfolio holding companies (like mutual funds in other countries) at the local or central level. It would further promote market integration if the local holding companies held a proportion of their portfolio outside their own provincial area, and if limits on their holdings in any individual company or geographic area could be adopted. (b) The passing of regulations to permit pension funds and insurance companies to purchase shares, with clear guidelines on the proceeds of such sales, and, again, limits on their individual shareholdings. Peter Harrold on Zhou Xiaochuan 155 (c) The creation of specialized sector holding companies, and assignment of shares in SOEs to those companies, but with maximum holdings in each company so that they did not become a new form of monopoly. (d) The leasing of enterprises currently under state ownership to managers, other enterprises (including in particular nonstate and foreign-invested enterprises), or to even to workers. (e) In some experimental cases, the exchange of shares for existing bank debt, with the creation of specialized investment companies or venture capital companies as subsidiaries of banks to manage such portfolios. (f) The passing of regulations to permit nonstate enterprises to obtain shares in SOEs and permission to nominate representatives on enterprise boards. (g) Sales to the public through stock exchanges. The fourth issue is that current regulations and policy pronouncements treat all SOEs the same, and fail to distinguish between different types of enterprise. We noted earlier that there are sociopolitical reasons why China is likely to retain public ownership (broadly defined) of a large number of enterprises for some time. Moreover, many enterprises would be likely to remain in public hands because of high entry costs, or because of the heavy social obligations of the very large SOEs, even though such enterprises would be expected to operate on a profit-maximizing basis. However, there are many enterprises that happen to be state-owned and are already operating in a competitive environment, such as enterprises in processing industries. We see no reason in the present policy framework for such enterprises to remain fully in state hands, and we do not believe that China has any ideological attachment to such ownership. Therefore, it would seem appropriate to develop programs to assist China with the partial privatization of such enterprises to begin with, and with undertaking exercises to identify candidate enterprises for such ownership diversification. Restructuring Issues Many restructuring exercises in China in the past have involved the employment of foreign consultants to carry out a subsector strategy study and restructuring plan, which is then "sold" to the ministry or provincial government concerned and implemented under an externally financed project. While this may solve the short-term problem, and help to set a good example for others to emulate, it does little to create the institutional capacity within China to replicate it, and this is an issue that should be addressed in future. A related issue in this regard is not only to develop the public sector capacity to restructure existing enterprises, but also to foster the sort of tertiary industry that will assist in this process, as well as assisting more generally in the promotion of the role of the market, and this refers to such professions as accountancy and consulting, as well as accounting rules. 156 Comment A second aspect related to restructuring is the quality of management. The skills that have been required to manage an SOE until now are likely to be very different from those that will be required to manage a large market-oriented corporation. In many instances, it may require new factory directors. However, the promotion of retraining in modem management techniques also seems to be worthy of support. Private/Nonstate Sector Development The growth of the nonstate sector-both collective and foreign-invested enterprises, as well as smaller individual firms-has been truly remarkable over the last decade and has served to create a competitive environment in many parts of the economy. In many respects, therefore, this aspect of policy is fine, and should be left as it is. The development of the nonstate sector in China has demonstrated to the authorities what is possible when they remove restrictions and permit entrepreneurs to fill market niches and to meet demands unmet by the inflexible state sector. However, most indigenous nonstate development has been in rural areas, with urban nonstate development being centered on foreign-invested enterprises. Moreover, it can reasonably be argued that most of the barriers that do still exist are economic rather than administrative, in the sense that costs of entry in many subsectors have been beyond nonstate industries at the present stage in their development. The remaining administrative barriers are essentially monopoly barriers, and should be addressed through competition policy, as discussed earlier, and through the abolition of "nonpriority" sectors for which foreign direct investment is considered unacceptable for capacity reasons. Aside from these, there are three basic issues that merit attention: (a) The government has no positive policy towards the nonstate sector, frequently leaving it out of legislation or regulations, as we discussed. (b) The nonstate sector has received good access to credit through rural institutions, but the government is very reluctant to permit nonrural financial institutions to lend to nonstate industry, and access to the resources of, for example, ICBC and PCBC is well below the nonstate sector's share of output. This reflects the relative interests of urban and rural governments. (c) The government has done very little to promote the provision of services to nonstate industries, with the notable exception of the SPARK program. D. CONCLUDING REMARKS In summary, and leaving aside the more general policy issues, several key broad issues seem to emerge from Zhou Xiaochuan's paper and from this review to define a new program for state asset management in China: Peter Harrold on Zhou Xiaochuan 157 * corporatization of SOEs in the form of joint stock companies should be the norm for a wide range of SOES in China; * a range of ownership institutions needs to be developed and tested; * diversification of state ownership should accompany this improvement in state asset management; * a range of new service industries will need to be promoted; * the legal framework for all this to occur still has a long way to go, and deserves equal attention with these governance issues. Anjali Kumar on Zhou Xiaochuan 159 COMMENTS ON "REFORM SEQUENCING AND STATE ASSET MANAGEMENT IN CHINA" by ZHOU XIAOCHUAN Anjali Kumar 1/ A. INTRODUCTION This paper provides a wide range of ideas and options for the transformation of the management of state-owned enterprises, without necessarily engaging in privatization. My comments on this paper are restricted to the last section, which describes proposals for the establishment of state-owned holding companies in China. The proposals in this paper bear a strong resemblance to holding company structures established in other developed and developing countries, as well as more recent proposed structures in some East European countries such as Poland and Romania. I would like to comment on some of the details of the proposed structure of holding companies presented here, in the light of the experience of other countries. B. APEX ComPAmEs First, looking at the proposed number and structure of holdings and subsidiaries, this paper suggests that up to 30 apex holding institutions could be established, with the same number of subsidiary holding companies below these, and similar numbers of operating enterprises in each of the subsidiary holdings. The number of apex holdings and subsidiary holdings proposed here appears large, by comparison with other countries. In Italy, which has a multilayered holding structure similar to the one proposed here, there are no more than three apex institutions. Algeria has eight apex holding companies, but no subsidiary-level holdings. One country that did have a large number of essentially sectoral apex holdings (38) was Egypt, and it was difficult to distinguish these holdings from industrial bureaus. The paper has alluded to principal-agent issues in the indirect management of enterprises. The difficulties of asymmetric information that form the core of such issues are aggravated in multilayered holding companies, as the number and layers of principals and agents multiply. Empirically, holding companies have tended to be more successful when their design as well as their objectives are relatively simple. C. ENTERPRISE-OWNER LINKs Next, looking at the links between state enterprises and their owners in this proposed framework, dividend payment by operating enterprises to their holdings, or even by the holdings to their overseeing Government Commission, is not deemed necessary, as long as the enterprises are undercapitalized. While it is true that theoretically it can be I/ Anjali Kumar is Senior Economist in the Country Operations Division, China and Mongolia Department, The World Bank. 160 Comment shown that the decision to distribute dividends should not affect the value of the firm, as unpaid dividends will then add to the capital value of the enterprise, the flexibility of choice should remain with the owners, in any given situation, and not determined on an a priori basis. In terms of links between owners and managers, or the vertical linkages between holding companies, it is proposed in this paper that appointments should be made on a hierarchical basis. This is certainly preferable to the appointment of senior persons at all levels by the apex, but it should be recognized that, in practice, it is difficult to avoid the influence of the top, in this case the Commission, or possibly political influence, in appointments. The introduction of regulations on the inclusion of external professionals, particularly among Board members, can help guard against this to some extent. In the example presented here, each enterprise is wholly owned by the holding company above it. However, the paper adds that the same logic would apply if joint holdings or cross-holdings were permitted. In such cases, a number of questions arise, concerning the distribution of shares among different holdings, which concern the expected role of the holding company. If a large part of the shares (majority or even dominant) are held by a single holding company, it is better able to undertake functions that may require strong managerial decisions, for example, the restructuring of an enterprise. More scattered shareholdings are suitable if the ownership function is expected to be exercised primarily through share trading and portfolio management. However, the ownership concentration in the former case may lead to greater interference in day-to-day management. Conversely, the ownership diffusion in the latter case may imply that there is inadequate disciplinary oversight. A decision on objectives, which takes these trade-offs into account, must precede a decision on share distribution structure. A proposal for the transition into this structure is presented here, and it involves the corporatization of some state enterprises. In this context, it must first be pointed out that form of the prior process of "corporatization" in this exercise is an extremely important determinant of subsequent performance. The mere process of conversion to joint stock companies does not necessarily affect the operating enterprises' efficiency, or independence from the ownership of the state. In some countries where public enterprises have been converted to joint stock companies through a process of corporatization, the new form of corporate law may be as restrictive as the state enterprises' operating framework. An example is provided by Egypt, which "corporatized" its public enterprises in 1983, but under a special State Enterprise law that was as restrictive as before. In 1991, Egypt made another attempt to proceed with "corporatization," through a new Public Enterprise Law. The new law stated that the laws for private enterprises would apply, with some exceptions. However, the list of exceptions was many pages long. On ownership of the new holding companies, one proposal offered in this paper is the ownership of enterprises by banks or other financial institutions. In the case of enterprise that are heavily indebted to banks with large arrears of payments, it is suggested that debt-equity conversions would simultaneously recapitalize the enterprises, Anjali Kumar on Zhou Xiaochuan 161 and provide the financial institutions with ownership stakes in the enterprises. This proposal should be treated with extreme care. The conversion of bad debt to bank equity in Italy in the late 1920s, following the stock market collapse of 1929, led to a situation where the banks were not only insolvent, but also illiquid. This was the origin of the establishment of the first large industrial state holding company in Italy; it was set up to bail out the insolvent banks, by removing their equity holdings in enterprises and transferring them to the state holding company. The United States also has strict restrictions against the ownership of enterprise by banks. While this is not universally true, it does illustrate that this route requires extreme caution. Finally, it should be mentioned that, extrapolating from the experience of other countries, there are many instances in which holding companies have been successful in achieving some degree of separation of ownership and management, as well as undertaking successful restructuring of enterprises. However, insulation against pressures from higher levels is difficult. Conversely, it has proved equally difficult to insulate the government against continuing financial demands from state enterprises under holding companies. The achievement of financial independence is extremely rare. Shahid Javed Burki 163 CLOSING REMARKS AND CONCLUSIONS Shahid Javed Burki We have now come to the end of three days of very useful discussions. I am now faced with the task of trying to summarize the outcome as we see it, and to meet the challenge that I set out at the start of the conference of defining a concrete set of recommendations for policy. I will present our set of recommendations in three parts: actions for the short term; reform of the institutional framework for macroeconomic management; and medium-term policy initiatives. SHORT-TERM ISSUES The first thing to emphasize is that the economy is overheated already, as evidenced by the accelerating inflation rate and the widening gap between the official and swap market exchange rates. The government should therefore take actions to deal with the situation beyond what has already been done. Further, it is clear that the main source of the overheating is excessive fixed investment growth, facilitated by an accommodating monetary policy. Timely actions would offer the best chance to return the economy to a path of steady, sustainable growth. We believe that while China can rely to a greater extent than before on indirect instruments, some direct controls are going to be necessary. A package of measures is necessary to address the short-term situation. The most important seem to be the following: (a) Interest rates should be raised to positive levels on both deposit and lending rates, because of a possible flight from bank deposits to other domestic and foreign assets, or into consumer goods.1/ This would indicate that the one-year deposit rate would need to go up at least 3-5 percentage points, from its present level of 9 percent, and that other rates should also be adjusted with an appropriate spread for different terms. Lending rates should be raised by even more, as they were raised by less than 1 percentage point earlier. Consideration should be given to the reintroduction of index-linked deposits for maturities of one year or more, in order to remove the fears of depositors that their savings would lose value. (b) This interest rate increase would also have to be reflected in the rates offered on government bonds. It may be desirable to explore marketing of these bonds via the financial system, as was tried last year, permitting the market to determine the appropriate rate of interest. In any event, we do I/ The current yields in the secondary markets for bonds are of the order of 14-16 percent at the present time, and interbank market rates are in the 16-20 percent range. These rates offer a further indicator of the extent to which present bank deposit rates are out of line. 164 Closing Remarks and Conclusions not see any reason for other financial transactions to be held up pending completion of these bond sales. (c) Given China's current industrial and financial structure, an interest rate increase alone may not dampen the growth in investment. The interest rate adjustment should be accompanied by comprehensive measures to tighten up the financial system. These include: (i) Enforcement of banking system liquidity and prudential requirements, together with measures to reduce the liquidity of banks. This could be by special deposits or by raising reserve requirements. These should be backed up by a strong policy limiting PBC credit to other financial institutions, and the granting of such credit should be the responsibility of the PBC itself, rather than being delegated to its branches. (ii) Extension and enforcement of licensing arrangements and regulatory procedures, such as reserve requirements, to nonbank financial institutions. There is no reason for any such institution to be exempted from these requirements. (iii) Rigorous enforcement of more widely defined credit ceilings, which should be applied to all financial institutions involved in lending activities. (iv) Prohibition of undesirable practices such as the leakage of funds from the interbank market to the nonbank financial institutions, with such prohibitions backed up by more frequent random checks on banks. (d) Some more direct means of controlling investment, particularly by state- owned units at the local level, would have to be considered. Work should begin now in the Planning Departments at the central and local levels, to determine investment priorities within the state-owned sector, the main source of expansion. While we recognize that there will be resistance to enforcing Planning Commission controls over investment at the local level, a key task for the central government at the present time is to achieve consensus on the need for a reduced investment rate, a theme to which I shall return later. (e) The external accounts have become much more affected by monetary policy, and more generally, by the level of confidence in the economy, than in the past. The widening gap between the official and swap market rates is a good indication of this, and especially of the impact of the low interest rate. This suggests the immediate acceleration of reforms of the foreign exchange system. We would recommend that government gives up its access to Shahid Javed Burki 165 export receipts at the present official rate, and trades entirely at the market rate. Moreover, the retention quota system should be abolished at a very early time. This should help to move China rapidly towards a unification of the exchange rate, which is a prerequisite for moving to current account convertibility.2/ The target date for unification of the two rates should be as soon as possible, but be preceded by the interest rate and exchange system reforms indicated. (f) China has moved rapidly to open up the capital account of the balance of payments, for example by allowing Renminbi to be exported by individuals going overseas. We fear that this opening was premature, and has affected the short-term situation by encouraging capital flight and hoarding of foreign exchange. Maintaining capital account controls for a longer period seems quite normal to us, and therefore the government should consider rolling back these changes for a few years. (g) We remain of the view that imports can have a strong role to play in absorbing excess demand in the short term, and that, assuming that monetary balance can be restored, trade liberalization would contribute both to short-term stability and to medium-term efficiency. (h) Finally, we want to observe that the current price pressures should not slow up the ongoing price reform process in any way. Indeed, price reform, especially in the area of energy pricing, would help to curb excess demand. Therefore, the recent success in this area should be continued as intended. INSTrIruONAL REFORMS I observed in my opening statement that the fact that the economy is overheated is symptomatic of the imperfect development of the instruments and institutions of indirect economic management in China. I therefore expressed the hope that we would look beyond the difficulties of the short term and focus on what has to be done over the medium term to prevent them from recurring every few years. These necessary steps are of two types, and first I will focus on the institutional changes that are needed if China is going to be able to improve macroeconomic management. I would also note at this juncture that for such institutional changes to be effective would require a well-functioning and well-qualified public sector, which will need to be adequately compensated. Increasingly, government will need to compare the remuneration it is offering with salaries being offered in the nongovernment sector. Let me mention four areas of institutional priority: (a) People's Bank of China: the role of PBC would have to be reformed in various ways in order to turn it into a real central bank instead of the hybrid it is today. This requires the complete separation from PBC of all 2/ Full convertibility of the Renminbi would only come several years later. 166 Closing Remarks and Conclusions noncentral bank functions, and especially the profit-making activities such as ownership of securities companies and mutual funds. These activities derive from the profit retention system for PBC, and this should be abandoned, with profits being remitted to the Ministry of Finance. The functions and number of branches of PBC should be reduced considerably, and we would repeat the frequently made suggestion to reorganize the PBC branch network into a limited number of regional branches, as with the US system. Surplus branches and staff could perhaps be spun off into a new commercial bank. We are, in other words, recommending a fairly significant restructuring of the People's Bank. The restructured PBC should focus on its primary role as a central bank: the maintenance of price stability and the associated preservation of value of the currency, and the promotion of the highest rate of growth compatible with this. We welcome the news that a Central Banking Law is to be passed soon, and hope that it incorporates these principles. We also hope that such a Law will reinforce the autonomy of the central bank, by creation of a Monetary Board to guide its work. (b) Policy Lending: We recommend the removal of policy lending from the banking system. We note that this type of lending falls into two categories: first, subsidies, mostly on loss-making state-owned enterprises and for agricultural procurement. This type of lending belongs to the budget. The second category, priority investment, especially in long-gestation or very expensive projects, belongs to an institution similar to the "policy banks" described by Chinese economists, although we would usually call them development banks. Indeed, this is what the World Bank is itself. These investments could be financed by government-guaranteed bonds. This would obviously be accompanied by refocusing the attention of existing banks on commercial activities. This will require much-strengthened supervision capacity in the central bank, on which efforts should be undertaken immediately. (c) Asset Diversification: many of the current problems of macroeconomic management have their origin in the buildup of deposits in the banking system, which are the only available assets for most households, whose savings have increased significantly during the reform era. Greater financial stability and ease of management would be derived from a diversification of assets for the household sector, notably through housing and pension funds, as well as various types of securities. (d) Macroeconomic Policy Formulation: One issue that I raised in my opening remarks was the need for an institution below the level of the State Council to formulate macroeconomic policy. It would not be appropriate for the "foreign monks" to advise on which of the present institutions, if any, should evolve into this role, as this is an internal matter for China to determine, but it is clear to us that such an institution is necessary. Shahid Javed Burki 167 (e) Ownership Issues: Macroeconomic management requires an appropriate microeconomic foundation. This means reforms to make enterprises-and this essentially means the state-owned enterprises-more responsive to the signals provided by indirect economic instruments such as the interest rate. The key to this still seems to lie in the clarification of property rights. We feel that there is considerable gain to be made from the corporatization of China's state-owned enterprises under an appropriate and unified framework of corporate law. This should be accompanied by the creation of suitable ownership institutions. There would need to be a number of experiments in this regard to find appropriate models. We also feel that government could be more aggressive in diversifying ownership of state assets. MEDIUM-TERM REFORMS The institutional changes, which need to be begun soon, but which obviously will take time to complete, would also need to be accompanied by a range of related policy reforms. These are complex and can only be touched upon in this context. Fiscal policy is the first of these medium-term reforms. There is an urgent need for putting fiscal reform high on the policy agenda of China's leaders. We believe that the failure of recent reform experiments in this regard suggests that a new reform style may be necessary in this context. This would entail the formulation of policy and its gradual implementation as enterprise and fiscal contracts expire. However, there is an urgent need now for reforms to equip the Chinese government with the sort of fiscal system that would permit it to utilize fiscal policy for the purposes of macroeconomic management. Such a system would have to be built in such a way as to avoid the procyclical features of the existing system. Further, it is important to stem the constant decline in the ratio of revenue to GDP. We recommend the following as areas of high priority: (a) Rationalization of the tax structure, by broadening the base, especially through Land and Property Taxes, Personal Income Taxes, and a "VAT with Chinese characteristics." This also calls for early implementation of the long-postponed "separation of taxes and profits," with consideration being given to the grandfathering of earlier arrangements for the tax deductibility of principal repayments. (b) In the area of enterprise taxation, the primary goal should be equal treatment of enterprises regardless of ownership, and we look forward to the early passage of the Enterprise Tax Law. (c) Reforming center-local fiscal relations, with a move away from fiscal contracts. The number and scope of local taxes (such as property taxes), and central taxes (such as corporate taxes) should be expanded over time to cover as large a portion as possible of respective expenditure responsibilities, with an associated reduction in "shared" taxes. We are of 168 Closing Remarks and Conclusions the view that such a reform would probably require the creation of a national tax service. (d) Improving the budgetary framework, by equipping the budget for its role as a policy tool. This would require three things in particular: unification of all government expenditures in the budget; the direct link of the budget with the economic situation and outlook; and the adoption of modern budgetary techniques. In the meantime, it is vital for MOF to strengthen oversight of budget implementation to avoid the recurrent overruns, especially on administrative expenses. Regional income policy is the second area I want to touch upon. We are concerned about the growing disparities between the coastal provinces and the rest of China. This has become most acute because of the recent boom occurring primarily in a relatively few provinces. We have several suggestions in this regard: (a) First, such disparities would be ameliorated by an early completion of energy and grain price reform, as the very low prices for these commodities have kept incomes down in these areas. Such a policy would, of course, have a variety of related benefits. (b) In the medium term, the fiscal program should be designed in such a way as to provide the central government with sufficient resources to meet its income transfer objectives. We recognize that this will take time, given the weak starting point for the budget. In the meantime, a contribution to the transfer of resources from the prosperous to the poor provinces could continue to be provided through differential credit controls. As the fiscal system develops, and as credit controls are lifted, this practice would fade away. (c) Many inland provinces have their locational disadvantage compounded by a policy disadvantage. Treatment of foreign investment and the development of the market economy should, as a minimum, not be biased against the inland provinces. This would be facilitated by central government action to ensure unrestricted movement of goods and capital between provinces by the development of an appropriate physical and institutional infrastructure. Incomes Policy is the third area. The move towards a market economy has raised a number of problems in the area of income distribution and the disappearance of the earlier social safety net. We feel that any solution to this problem should be compatible with the market economy, and that there is a danger of a "planning" solution being attempted in the form of a wage control policy. Rather, we consider that the solution should be sought in the following areas: Shahid Javed Burki 169 (a) The change in the structure of incomes calls for a strong effort in the area of personal income tax, which should cover wage and nonwage benefits to the extent possible. (b) The proposed implementation period for proposed reforms in the areas of pension systems, unemployment insurance, housing reform, and health insurance is too long, and should be accelerated. These we consider to be of particular importance not only for the reform of the state-owned enterprises, but also for avoiding income inequality. (c) The solution to many other problems emerging in this area as a result of the reform, such as the very high gains being made in such sectors as real estate and the stock market, would be better addressed by removing the artificial supply side constraints and thus reducing the rents to be earned from such transactions. The suggestion of moving to an auction system for land and property transactions seems to us to have considerable merit. This is a very long and challenging agenda that we have put up, both for the short and the medium term. Its adoption and implementation will require the emergence of consensus among policymakers at various levels of the government. It is essential for senior leaders to actively cultivate both a better understanding of the current economic situation, and to foster a realization that concerted action will ultimately benefit all areas. Translating this agenda into action-particularly the items related to institutional and organizational reforms such as reform of the fiscal system, analysis of regional disparities, and the further analysis and reform of the state-owned enterprise sector in China-will require considerable additional analytical work. We look forward to discussions with the System Reform Commission and the Ministry of Finance to see how we can follow up this conference with more detailed work to help define reforms in these key areas. I believe that this conference has been very useful, and that its timing was very appropriate. We hope that these deliberations will prove beneficial to China's policyrmakers as they struggle first to overcome the present difficult situation of an overheated economy, and then to seek to put in place the necessary reforms to avoid a recurrence of such situations in the future. We in the World Bank very much look forward to the challenge of working with you in these areas, and lending whatever support we can to this most critical endeavor. Thank you. List of Participants 171 LIST OF PARTICIPANTS Foreign Paricipants Prof. Lawrence J. Lau Kwoh-Ti Ling Professor of Economic Development, Department of Economics, Stanford University Prof. Nicholas R. Lardy Professor of Economics, Henry M. Jackson School of International Studies, University of Washington, Seattle Prof. Athar Hussain Associate Professor, London School of Economics Prof. Nicholas Stem Chief Economist, European Bank for Reconstruction and Development Dr. Cyril Lin Director, The Centre for Modem Chinese Studies, Oxford University Christopher Allsopp Fellow, New College, Oxford University World Bank Mr. Shahid Javed Burki Director, China and Mongolia Department Mr. Edwin R. Lim Director, Western Africa Department Mr. Peter Harrold Principal Economist, China and Mongolia Department Ms. Anjali Kumar Senior Economist, China and Mongolia Department Mr. Bert Hofman Economist, China and Mongolia Department World Bank Resident Mission in China Mr. Pieter Bottelier Chief of Mission Mr. E.C. Hwa Senior Economist Ms. Chingboon Lee Senior Economist 172 List of Participants Chinese Participants System Reform Commission Mr. Wu Jie Vice Chairman Mr. An Zhiwen Chairman of Economic System Reform Research Association Mr. Gao Shangquan Vice Chairman of Economic System Reform Research Association Mr. Ye Sen Director, Foreign Affairs Department Mr. Lou Jiwei Director, Macroeconomic Department Mr. Sun Yanfu Director, Laws and Regulations Department Mr. Li Yuan Director, Distribution Department Mme. Li Qingyuan Deputy Director, Macroeconomic Department Mr. Peng Sen Deputy Director, Department of Comprehensive Programming and Experimenting Department Mme. Xu Meizheng Deputy Department Director Mme. Ma Guofeng Deputy Department Director Ministry of Finance Mr. Tian Yinong Advisor Mr. Liu Kegu Deputy Director, Finance Reform Department Mr. Jin Liqun Deputy Director, World Bank Department State Planning Commission Mr. Guo Shuqing Deputy Director, Macroeconomic Department, Economic Research Center Mr. Liu He Deputy Director, Industrial Policy Department People's Bank of China Mme. Wu Xiaoling Deputy Director, System Reform Department Mr. Xie Ping Division Chief, Finance Department Bank of China Mr. Zhou Xiaochuan Vice President State Council Policy Research Office Mr. Su Ning Deputy Department Director China Academy of Social Sciences Mr. Dai Yuanchen Professor, Economic Institute List of Participants 173 State Taxation Administration Mr. Yang Yimin Division Chief, Tax Reform Department China Hainan Reform and Development Institute Mr. Chi Fulin Vice President Conference Working Staff World Bank Resident Mission in China Mr. Xingdong Chen Research Economist Ms. Susan Su Secretary System Reform Commission Mr. Wang Zangqun Mr. Wang Haijun Mr. Zhang Xiaochong Mr. Pu Jingduo Mr. Li Keping Mr. Gao Jianhong Mr. Guo Xiangjun Ministry of Finance Mr. Feng Yushu Ms. Zou Jiayi Mr. Wang Xuejun Conference Interpreters Ms. Fang Qiaoling Mr. Zhang Jianmin Ms. Zhu Tong Distributors of World Bank Publications ARGENTINA The Middle East Observer KENYA SOUTH AFRICA, BOTSWANA Carlos Hirsch,SRL 41, Sherif Street Africa Book Service (EA) Ltd. 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Edited by Alcira Kreirner, Thereza Lobo, Braz Menezes, Mohan Munasinghe, and Ronald Parker No. 196 Eastern Europe in Transiton: From Recession to Growvth?: ProccedingV of a Conference on the Macroecoonmic Aspects of Adjustmnct, Cosponsored by the International Monetary Fund and the World Bank. Edited by Mario 1. Blejer, Guillermo A. Calvo, Fabrizio Coricelli, and Alan H. Gelb No. 197 Korean Industrial Policy: Leg'acies of the Past and Directonsfor the Future. Danny M. Leipziger and Peter A. Petri No. 198 Exporting High-Value Food Cotmodities: Success Storiesfrom Developing Countries. Steven M. jaffee with the assistance of Peter Gordon No. 199 Borrter Ownershtip ofAid justient Pr,rams and the Political Economy ofReform. john H . johnson and Sulaiman S. Wasty No. 200 Social Infrastrucolre Construction in te Sahel: Options for ltiproving Current Practices. Bernard Abeilé and jean-Marie Lantran No. 201 Urbanization, A,riciltural Dev,eloptent, and Liid Alocation Dipasis Bhadra and Antônio Salazar P. Brand:o No. 202 Makint, Mlotlierhood Safe Anne Tinker and Marjorie A. Koblbnsky No. 203 Poverty Reduction in East Asia: The Silent Revohition. Frida Johansen No. 204 Managing the Ciwil Serue: The Lessons of Reforim in Industrial Countries. Barbara Nunberg No. 205 Desifning a System of Labor arket Statistos and Information. kobert S. Goldfarb and Arvil V. Adams No. 206 fmforination Tecinoloy in World Bank Lending: ficreasmg the Developmien tal Impact. Nagy Hanna and Sandor Boyson No. 207 Proccedingis ofa Coterence on Crrency Substitution and Curremcy Boards. Edited by Nissan Liviatan No. 208 Developing Ec<er Etttploymtet Services. David Fretwell and Susan Goldberg No. 209 Evolviig Leval Frantew,orks for Private Sector Developnent in Central and Fastern Europe. Chieryl W . Gray and Associates No. 210 Marine Biotecitologqy and Developtie Countries. Raymond A. Ziniskas and Carl Gustaf Lundin No. 211 Revitalizm Agriculttral Research in tie Sael: A Proposed Frameworkfor Action. jan Weijenherg, josué Dioné, Michael Fuchs-Carsch, Adolphe Kéré, and jacques Lefort No. 21 2 Institutional Options for tle Provision of lnarstructutre. Christine Kessides No. 21 3 Thie Contributions of Infrastriictiire to Etoniomtii- Det'elopnt et: A Reviewi of Experience and Political lupications. Christine Kessides No. 2 14 Fromi Macroecotnotmt ic Correction to Public Setor Reform: lje Crital Role of Etvaltujatioln. Eduardo V Vesner D. No. 215 Cltma: Reformn and Development m 1 992-93. Peter Harrold and Rajiv Lall No. 216 The Reform of Pttblic Expetiditiris-for Agriciltiire. Bonni van Blarcom, Odin Knudsen, and john Nash No. 217 Managttt Fisliery Resores: Proceedin'5ys tfa Symposium Co-Sponsored by the World Batk and Pertuuiat A lmitry of Fisleres ield in Lima, Peru,_jite 1992. Eduardo A. Loayza No. 218 Cooperanive- and tlie Breaktip of Large MelCatmized Farms. Theoretial Perspctiies and Eipirital Etidence. K laus W. Deninger No. 219 Dei-eloptment of Rural Financial Alarkets in Suib-Sah,aratt Afria. Sabapathy Thillai rajab No. 220 The Maritine Transport Crisus. Hans ). Peters No. 221 Policy-Based Finantce: Ilie Experetce of Postiarjapan. Tlhe japaiese Dcvclopmienit Bank and The japan Economic Research Institute The World Bank Headquarters European Office Tokyo Office 1818 H Street, N.W. 66, avenue d'l&na Kokusai Building Washington, D.C. 20433, U.S.A. 75116 Paris, France 1-1 Marunouchi 3-chome Chiyoda-ku, Tokyo 100, Japan Telephone: (202) 477-1234 Telephone: (1) 40.69.30.00 Facsimile: (202) 477-6391 Facsimile: (1) 40.69.30.66 Telephone: (3) 3214-5001 Telex: wur 64145WORLDBANK Telex: 640651 Facsimile: (3) 3214-3657 RCA 248423 WORLDBK Telex: 26838 Cable Address: INTBAFRAD WASHINGTONDC ISBN 0-8213-2722-4