China - Public investment and finance

Report No. 14540-CHA China Public Investment and Finance October 18, 1995 Country Operations Division China and Mongolia Department East Asia and Pacific Regional Office Document of the World Bank  CURRENCY EQUIVALENTS (As of January 1995) Currency Name = Renminbi Currency Unit = Yuan (Y) I Yuan = 100fen Y 1.00 = $0.11 $1.00 = Y 8.5 FISCAL YEAR January i - December 31 WEIGHTS AND MEASURES Metric System  ACRONYMS AND ABBREVIATIONS ABC - Agricultural Bank of China AIP - Annual Investment Plan BMD - Budget Management Department BOC - Bank of China BOT - Build Operate Transfer CC - Capital Construction CCD - Capital Construction Department CEM - Country Economic Memorandum CIECC - China International Engineering Consulting Company CITIC - China International Trust and Investment Corporation EBF - Extra Budgetary Funds FAO - Food Agriculture Organization FDI - Foreign Direct Investment FEBF - Fiscal Extra Budgetary Funds FYP - Five Year Plan GDP - Gross Domestic Product GNP - Gross National Product ICBC - Industrial and Commercial Bank of China IMF - International Monetary Fund ITIC - Investment and Trust Corporation JV - Joint Venture LMS - Large and Medium Size MCC - Municipal Construction Commission MPB - Municipal Planning Bureau MOF - Ministry of Finance MOFTEC - Ministry of Foreign Trade and Economic Cooperation NBFI - Nonbank Financial Institution NPC - National People's Congress PBC - People's Bank of China PCBC - People's Construction Bank of China PCC - Provincial Construction Commission PFB - Provincial Finance Bureau PICC - People's Insurance Corporation of China PIP - Public Investment Program PPB - Provincial Planning Bureau PRC - People's Republic of China PSD - Provincial Sector Department RCC - Rural Credit Cooperatives SAEC - State Administration for Exchange Control SDB - State Development Bank SERC - Securities Exchange Regulatory Commission SETC - State Economic and Trade Commission SIC - State Investment Corporation SIDC - State Investment Development Corporation SPC - State Planning Commission SRC - State Commission for the Restructuring of the Economic System SOE - State-Owned Enterprise SOU - State-Owned Unit TIC - Trust and Investment Corporations TT - Technical Transformation TVE - Township and Village Enterprises UCC - Urban Credit Cooperative WDR - World Development Report   CONTENTS CONTRIBUTORS ......................................................... vI SUMMARY AND RECOMMENDATIONS ......................................................... vii A. MAIN FINDINGS ..................................................................... vii B. ISSUES FOR REFORM ......................................................... ;X C. RECOMMENDATIONS ......................................................... xi 1. BACKGROUND AND TRENDS IN CHINA'S INVESTMENT ...................................... I A. INTRODUCTION ...........................................................1 B. TRENDS [N INVESTMENT ...........................................................2 Ownership ...........................................................3 Sources of Finance ...........................................................7 Sectoral Composition of State Investment ...................... .................................... 12 C. PUBLIC INVESTMENT: ACHIEVEMENTS TO DATE .......................................................... 14 Overview: China's Public Investment in International Perspective ..................................... 14 Sectoral Trends .......................................................... 16 Level of Government .......................................................... 1 8 2. INVESTMENT SYSTEM: EVOLUTION, PLANNING AND FINANCE ...................... 20 A. ECONOMIC REFORMS AND THE INVESTMENT SYSTEM ..................................................... 20 The Planned Economic System .......................................................... 20 Economic Diversification .......................................................... 21 Erosion of Government Budgetary Resources ................................... ....................... 22 Investment Reforms .......................................................... 22 B. ISSUES .......................................................... 26 Budgetary Finance and the Dispersion of Government Effort .............................. ................ 27 Financing Local Govemment Investment: Efficiency, Equity and Macroeconomic Control29 Proliferation of Extrabudgetary Funds ...................................................... 31 Reducing PBC's Quasi-Fiscal Activities ...................................................... 34 Pervasive Government Control Over Investment ...................................................... 35 Stop-Go Cycles ....................................... . 38 Investment Efficiency ....................................... 40 3. A FRAMEWORK FOR PUBLIC INVESTMENT ....................................... 44 A. THE GOVERNMENT'S ROLE IN INVESTMENT: WHAT SHOULD IT BE? ............................ 44 Scope of Government Involvement: Normative Framework ................................................ 44 Public Investment Program: Alternative Definitions ...................................................... 46 B. INSTITUTIONS FOR MANAGING PUBLIC INVESTMENT ...................................................... 48 Medium Term Investment Program ...................................................... 48 Management of the Investment Budget ...................................................... 51 Loan Guarantees ...................................................... 52 Fiscal Extrabudgetary Funds ...................................................... 52 C. FINANCING PUBLIC INVESTMENT ...................................................... 53 Prospects for Increasing Resource Mobilization ...................................................... 53 Mechanisms for Capturing and Transforming Domestic Savings ....................... ................. 54 Mechanisms for Allocating Investments ...................................................... 58  - ii - D. A FRAMEWORK FOR FINANCING PUBLIC INVESTMENTS .................... ............................. 63 Building on Government Reforms .......................................................... 63 Who Would Invest in What and How Much? .......................................................... 65 ANNEX: THE INVESTMENT PLANNING AND FINANCE SYSTEM ........... ................ 67 A. PREPARATION OF THE ANNUAL INVESTMENT PLAN (AIP) ............................. ................. 67 Scope of the AIP .......................................................... 67 Investment Planning Process .......................................................... 67 Project Approval .......................................................... 68 Project Implementation .......................................................... 69 B. FINANCING PLANS ........................................................................ 71 Role of the Budget .......................................................... 71 The Credit Plan .......................................................... 72 Policy Lending Through the State Development Bank ......................................................... 75 Tapping the Capital Markets .......................................................... 77 Role of Different Actors .......................................................... 81 Tables in Text Table 1.1 Share of the State Sector in Industrial Output and Investment (in percent) . 4 Table 1.2 China's Industrial Enterprises: Fixed Assets to Net Output Ratios for the State and Nonstate Sectors, 1993. 5 Table 1.3 Share of Industry in Investment and Reliance on Credit, 1993 (in percent) .10 Table 1.4 Financing of Total Fixed Investment, 1993 (in percent) .12 Table 1.5 Sectoral Composition of State Investment .13 Table 1.6 China: Public Investments by Level of Government, 1992 .18 Table 2.1 Share of Central Government Budgetary Investment in Grant Form (percent). 23 Table 2.2 Key State Projects: Sectoral Composition .25 Table 2.3 Financing of State Investment, 1992 (in percent) .28 Table 2.4 Investment Efficiency Measures .41 Table 3.1 China: "Public" Investment, 1992 .47 Table 3.2 Sources of Savings (percent of GDP) .55 Table 3.3 State Fixed Asset Investment Structure and Sources of Finance: An Illustration (percent of GDP) .65 Figures in Text Figure 1. I China: Fixed Asset Investment by Ownership .......................................................... 4 Figure 1.2 China: Industrial Labor-Output Ratios .......................................................... 5 China: Industrial Investment-Output Ratios .......................................................... 5 Figure 1.3 China: Share of Central Government in State Investment .......................................... 7 Figure 1.4 China: Sources of Investment Financing .......................................................... 8 Figure 1.5 China: Structure of State Investment .......................................................... 13 Figure 1.6 China: State Investment in Infrastructure and Social Sectors, 1982-93 ................... 15 Figure 1.7 China: State Investment in Infrastructure and Social Sectors ................................... 18 Figure 1.8 China: Central and Local Fixed Investment, 1992 ................................................... 19 Figure 2.1 China: Financing Budgetary Investment Percent of GDP ........................................ 27 Figure 2.2 China: Investment Cycles and Credit .......................................................... 39 Figure 2.3 China: SOU Capital Construction and Investrnent Cycles ....................................... 39  - Ill - Figure 2.4 China: Project Size and Investment Cycles .................................................. 39 Figure 2.5 China: Decentralization and Investment Cycles .................................................. 40 Boxes in Text Box 1.1 Chinese Investment Termninology .3 Box 1.2 Center vs Local .6 Box 1.3 Credit for Investment: What is the Outstanding Stock? 9.9 Box 1.4 Own-Funds (Retaiined and Self-Raised) .1 Box 2.1 Local Government Borrowing .30 Box 2.2 Capital Transfers: International Experience .32 Box 2.3 Off-Budget and Earmarked Funds .33 Box 2.4 Earmarking: When is it Justified? 34 Box 3.1 Public Investment Program .50 Box 3.2 How Much do the Chinese Really Save? .54 Box 3.3 Government Policy and Enterprise Savings .56 Box 3.4 Specialized Infrastructure Investment Funds .58 Box 3.5 Policy Lending in Japan and Korea: The Ingredients of Success .61 Annex Tables and Figures Table Al.1 China's Industrial Enterprises: Fixed Assets to Net Outputs Ratios for the State and Nonstate Sectors, 1993 .85 Table A2.1 Financing of State Investment: Sectoral Composition by Funding Source, 1992 (in percent) .86 Table A2.2 State Investment in Infrastructure and Social Ssector, 1985-1993 (Percentage of GDP) .87 Table A2.3 Electricity Investment: 1992 Funding Source Breakdown ........................................ 88 Figures Figure A .1 China: Budgetary Outlays for Investment .89 Figure A 1.2 Expenditure on Education and Health (as percentage of GNP) .90 Figure A 1.3 Roads .91 Figure A 1.4 Water .92 Figure A 1.5 Power .93 Figure A 1.6 Telecommunications .94 Figure Al.7a Life Expectancy ............................................. 95 Figure A 1.7b Infant Mortality Rate ............................................. 96 Figure Al .7c Prevalence of Malnutrition and Percapita GNP ............................................. 97 Figure A1.8a Primary School Net Enrollment ............................................. 98 Figure A1.8b Primary Pupil/Teacher Ratio ............................................. 99 Figure A1.8c Adult Illiteracy Rate ............................................. 100 Figure A1.9 Telephone Mainlines per 100 Persons ............................................. 101 Figure Al.10 Telephone Sets per 1,000 Persons ............................................. 102 Figure A 1.11 Percapital Length of Roads (Paved + Unpaved) ............................................. 103 Figure A 1.12 Percapita Length of Paved Roads ............................................. 104 Figure Al1.13 Percapita Length of Railroad ............................................. 105 Figure Al1.14 Percapita Electricity Generating Capacity ............................................. 106  - iv - Figure Al .15 Percapita Electricity Production .................................................................... 107 Figure Al .16 Percent of Total Population with Access to Safe Drinking Water ...................... 108 Figure A1.17 Percent of Urban Population with Access to Safe Drinking Water .................... 109 Figure A1.18 Percent of Rural Population with Access to Safe Drinking Water ..................... 110 Figure Al1.19 Percent of Total Population with Access to Sanitation ....................................... 111 Figure A1.20 Percent of Urban Populatuon with Access to Sanitation .................................... 112 Figure A1.21 Percent of Rural Population with Access to Sanitation ...................................... 113 Figure A 1.22 Energy Investment .................................................................... 114 Figure A 1.23 Water Investment . .................................................................... I15 Figure A1.24 Transportation Investment .................................................................... 116 Figure A1.25 Telecommunications Investment .................................................................... 117 Figure A1.26 Social Sector Investment .................................................................... 118 Figure A2.1 Telecommunications .119 Figure A2.2 Power .120 Figure A2.3 Roads .121 Figure A2.4 Water .122 Figure A2.5 Large Investment Projects .123 Appendix Tables Table 1.1 Total Fixed Asset Investment (in million Yuan) ....................................................... 124 Table 1.2 Total Fixed Asset Investment (in percent) ................................................................ 125 Table 1.3 Total Fixed Asset Investment (as percent of GDP) ................................................... 126 Table 2.1 Total Fixed Asset Investment of SOUs by Sector (in million Yuan) ........................ 127 Table 2.2 Total SOU Fixed Asset Investment by Sector (in percent) ....................................... 128 Table 2.3 Total SOU Fixed Asset Investment by Sector (as percent of GDP) .......................... 129 Table 3.1 Capital Construction Investment of SOEs by Sector (in millionYuan) .................... 130 Table 3.2 SOU Capital Construction Investment by Sector (in percent) .................................. 131 Table 3.3 SOU Capital Construction Investment by Sector as percent of GDP) ...................... 132 Table 4.1 SOU Technical Updating and Transformation Investment by Sector (in million Yuan) .................................................................... 133 Table 4.la SOU Other Fixed Asset Investment (in million Yuan) .............................. 134 Table 4.2 SOU Technical Updating and Transformation Investments by Sector (in percent).. 135 Table 5.1 Financing of SOU Capital Construction Investment (in million Yuan) .................... 136 Table 5.2 Financing of SOU Capital Construction Investment (in percent) ............................. 137 Table 5.3 Financing of SOU Capital Construction Investment (as percent of GDP) ................ 138 Table 6.1 Fixed Asset Investment of Urban Collectives by Sector (in million Yuan) .............. 139 Fixed Asset Investment of Rural Collectives (in million Yuan) ............................... 139 Fixed Asset Investment of Collectives by Sectors (in million Yuan) ....................... 139 Table 6.2 Fixed Asset Investment of Urban Collectives by Sector (in percent) ....................... 140 Fixed Asset Investment of Rural Collectives by Sector (in percent) ........................ 140 Fixed Asset Investment of Collectives by Sector (in percent) .................................. 140 Table 6.3 Financing of Urban Collectives Investment (in million Yuan) ... ............................. 141 Financing of Rural Collectives Investment (in million Yuan) .................................. 141 Financing of Collectives Investment (in million Yuan) ............................................ 141 Table 6.4 Financing of Urban Collectives Investment (in percent) .......................................... 142 Financing of Rural Collectives Investment (in percent) ............................................1 42 Financing of Collectives Investment (in percent) ..................................................... 142  - v - Table 7 Fixed Asset Investment by Individuals (in million Yuan) ........................................ 143 Financing of Other Investment (in million Yuan) .................................................... 143 Table 8.1 China: Fixed Investment in State Owned Units in 1992 (Billion Yuan) .................. 144 Table 8.2 China: Fixed Investment in State Owned Units in 1992 (in percent) ....................... 145 Table 8.3 China: Fixed Investment in State Owned United in 1992 (in percent) .................... 146 Bibliography ........................................................................................................................... 147  - vi - CONTRIBUTORS The scope of this report was determined during a preparatory visit to China in August 1994. Its contents are based on the findings of the main mission which visited China in October 1994. Mission members consisted of Tamar Manuelyan Atinc (mission leader and task manager), Albert Keidel (macroeconomic issues), Henk Koppen (consultant, public investment management), Barry Naughton (consultant, role of the government), Ignacio Mas (financing public investment) and Tejaswi Raparla (international comparisons). Gao Xiaoning (Beijing mission) also participated in the mission and provided excellent logistical support. Bert Hofman (budgetary finance) provided valuable comments on the entire report. In addition, the report benefited from a background paper prepared by the Investment Institute of the State Planning Commission; Mr. Jiang-hai's contribution is gratefully acknowledged. The World Bank team benefited from fruitful discussions with many government officials, who were generous with their time and knowledge. The team is particularly grateful to the Investment Department of the State Planning Commission for the smooth organization of the mission's work which would not have been possible without the dedication and efficiency of Messrs. Zhang Guobao and Wang Wansong. The team would like to extend its gratitude to the provincial and municipal authorities in Fuzhou and Zhengzhou whose insights were particularly enriching. Preparation of the report benefited from the excellent support provided by Cheryl Powell, Valerie Charles and Cyndi Dennis.  - vii - SUMMARY AND RECOMMENDATIONS A. MAIN FINDINGS China has been successful in allocating substantial resources into "public" investments.' Infrastructure investments reached 6.5 percent of GDP in 1993, well above the developing country average (4 percent) and close to the effort recommended in the 1994 World Development Report (7 percent). By comparison, social sector investments are low and declining. Education and health expenditures in 1993 were 3.5 percent of GDP, below the average (5.2 percent of GDP) for a group of fifteen Asian developing countries. China's achievements in infrastructure were predicated largely upon increased resource mobilization rather than a shift in allocation. The increased savings effort (9 percentage points of GDP since 1982) allowed the authorities to allocate incremental resources to infrastructure, without confronting the need to modify investment incentives and management in the rest of the economy. The main finding of this report is that China's investment system provides considerable scope for efficiency gains because investment reforms remain incomplete. While the Chinese investment effort will have to remain strong in order to maintain high levels of economic growth, investment reforms can generate efficiency gains which would allow, at the CHINA: SELECTED INVESTMENT INDICATORS (in percent) 1982 1993 As percent of GDP Total fixed asset investment 23.7 36.5 State investment 16.3 22.4 Central government investment 7.4 7.9 State infrastructure investment 3.1 6.5 State social sector investment 0.9 0.8 Financing: as percent offied investment Budget 22.7 3.7 Domestic credit 14.3 23.5 Foreign 4.9 7.3 Self-raised and other 58.1 65.5 The term "public" investment refers to the (public goods) nature of the investment and not to ownership. State investment covers investment by state-owned units (SOUs) at all levels of government but not by collectives, which are also publicly-owned. SOUs comprise enterprises as well as governmental entities.  - viii - same time, for more rapid increases in per capita consumption, and in government expenditures targeted at sustainable development. While the role of the government as investor has declined and there has been considerable diversificatioin in sources of investment finance, much of state investment remains centrally planned, with administrative controls rather than market forces determining its allocation. This reflects government efforts to maintain control over investment decisions even while most of the Chinese economy now operates on a market basis. The consequences of this tension between increasing decentralization in economic decision making, on the one hand, and continued reliance on detailed investment programming and strict centralized control over the allocation of funds, on the other, are discussed below: (a) Dominance of the state sector. State-owned unit fixed investment is very large, and shows no tendency to decline; state industrial investment is also much larger than the size of the state sector (share in output) would warrant, suggesting that the state industrial sector uses investment resources less efficiently than the rest of the economy. Credit rationing which favors the state sector in good times, does so even more during periods of tightening. Within the state sector, central government investment has remained substantial despite ongoing decentralization. Furthermore, it is largely shielded from the impact of cyclical downturns. (b) Dwindling budgetary resources and dispersion of government effort. Despite the shrinking share of budgetary investment funds, the government has continued to invest in nearly all sectors of the economy, creating serious difficulties in directing resources to areas where the needfor direct government involvement is greatest. (c) Pervasive government role in resource allocation. There is a substantial mismatch between the large government role in making investment decisions and allocating investment funds, on the one hand, and the limited importance of government financial resources, on the other. The perceived need to support investment in many areas leads the government to maintain an onerous investment approval mechanism and to direct financial resources (domestic bank credit, foreign borrowing, enterprise bonds and equity shares) to designated state projects in a way that crowds out other investment. Furthermore, while an increasing proportion of total investment is carried out with funds generated by the investing units, for the bulk of own funds, there are significant restrictions on the extent to which managers can respond to differences in risk and rate of return. Financial planning in China serves the dual purpose of managing monetary aggregates and directing resources towards designated projects. When the credit plan is successful in directing resources to their intended uses, it undermines enterprise autonomy in investment decisions. When it is unsuccessful, as in recent episodes of credit leakages, it assumes an expansionary bias as financing is sought from the People's Bank of China (PBC) to ensure availability for priority uses. The credit plan serves well neither its  - ix - aggregate demand management purpose nor its objective of channelling resources to priority projects. (d) Limited financial autonomy for local governments. Local governments have few funds for investment given limited tax autonomy and a prohibition on borrowing. This has several problematic consequences: efficiency gains remain unexploited, local government's borrow through enterprises under their direct control; the allocation of capital transfers through the planning system distorts local preferences and may reduce local fiscal effort; extrabudgetary funds proliferate, undermining the efficacy of the budget process; and governments continue to influence the use of enterprise retained earnings. (e) Inappropriate incentives structure. Current incentives continue to encourage overinvestment (given the low cost of capital and limited enterprise assumption of risk), aggravating economic cycles and lowering investment efficiency. In particular, the procyclical nature of local investment has systemic causes and effects. Local governments face a binding credit and administrative approval constraint on investment during periods of economic tightening; this induces overinvestment in periods of looser credit, thereby contributing to the likelihood of a contractionary phase in the future and to protracted investment periods. The state investment system's efficiency at converting inputs into outputs remains low and unchanged from the early 1980s, when economic reform had just begun. The large volume of incomplete construction (15-16 percent of GDP) and long completion times reflect the fact that resources, and in particular government resources, are spread too thinly over existing projects. Individual projects are underfunded and planning, organizational, and design capabilities are stretched beyond optimal points. B. ISSUES FOR REFORM China's transition from a planned to a market economy requires both the development of market institutions and a fundamental change in the role of the government in economic decisions. The Chinese authorities face an important challenge in further sharpening the distinctions between public ownership, on the one hand, and the provision and financing of public services, on the other. This involves reducing government involvement in SOEs to the more restricted exercise of ownership rights but remaining intimately engaged in the institutions, mechanisms and financing requirements for the provision of public goods. Reform of the investment system is an essential ingredient in this process and must take into account the following considerations: (a) Role of the Government. The government's willingness to refrain from influencing directly the overall pattern of investment and to allow greater decentralization in investment decisions is critical for further progress toward the establishment of a market economy. This requires delineating clearly the government domain in investment and sharpening the distinction between public ownership, on the one hand, and the provision and financing of public services, on the other. The present classification of investment into three categories is an  - x - improvement but the categories are too broad, and the concepts used too vague to be operationally useful. (b) Financing. Unlike most transitional economies, China does not need to mobilize additional resources in order to reach the minimum acceptable levels of (public) investment. Rather, the challenge is two-fold: (i) how to reduce overall investment demand to levels compatible with macroeconomic stability even while maintaining the flow of resources to public investments; and (ii) how to accomodate China's public investment financing needs in ways which do not compromise the further development of the financial system and increased enterprise autonomy. The system of investment planning, with its current reliance on quantitative allocation of financial resources, constitutes a major impediment to financial sector reforms. While the government's objective of separating policy and commercial lending is good, it is not enough by itself for the commercialization of the banking sector. Specialized banks are still subject to project-specific lending quotas; are obliged to provide working capital loans to SOEs; can only lend for government-approved projects; and have to finance the State Development Bank (SDB) through compulsory purchases of its bonds. Banks cannot operate on a commercial basis until project-specific credit allocation has been eliminated. Eliminating the credit plan's resource allocation function can, however, be contemplated only if alternative mechanisms are available for channeling resources to public investments. (c) Incentives and Links to Other Reforms. The government's objective of shifting project implementation responsibility to enterprises is a useful start in enhancing accountability and reducing cost-overruns. However, the fundamental issue of project risk remains unaddressed. While benefits accrue to the enterprises, the bulk of investment risk in the state sector still conveys to the government. This reflects incomplete reforms in the enterprise sector and the investment system. First, in the absence of hard budget constraints for enterprises and/or clear title or adequate equity stakes in investment projects, managers of investment projects remain the agents of the government in carrying out investment. Second, appropriate enterprise governance structures that protect and limit the rights of the government as owner have yet to be developed. Third, the cost of capital (thanks to low interest rates and payment defaults) is so low that investment demand continues to be insatiable. Fourth, extensive government involvement through its approval (SPC) and financing (SDB) institutions serves, to some extent, to absolve investors of the responsibility for the failure of a project. (d) Process and Institutions. The investment planning process reinforces incentives for overinvestment. Investment planning currently has a one year time horizon, even though most investments take several years to implement. In the absence of a multiyear programming framework, it is difficult to counteract the systemic incentives for presenting a constant stream of new projects for approval and always ending up with too many projects, with too little funding.  - xl - As it currently stands, the investment budget is not a meaningful instrument for implementing the government's priorities. The budget lacks transparency; monitoring and control of investment expenditures are split among three departments; foreign and domestic components of the same project are handled by different departments; consideration of linkages and trade-offs between recurrent and capital expenditures is inadequate; and clear guidelines on eligibility and terms for budgetary funding are often lacking. Project approval involves too many steps and too many agencies, with occasional duplication of functions. This is further complicated by the continued distinction between capital construction and technical transformation investments, which hinders a consideration of trade-offs. Furthermore, the project approval threshold remains too low. C. RECOMMENDATIONS This report's recommendations focus on areas for improvement in public investment management and financing. Equally important for the reform of the investment system as a whole is continued progress in the establishment of a market economy, which would remove incentives for overinvestment. Particularly important in this regard are the imposition of hard budget constraints on enterprises and financial institutions, through appropriate governance structures and competitive market discipline, completion of price reforms, and interest rate levels that reflect the scarcity value of capital. Recommendations for the reform of the public investment system are detailed below. Role of the Government. In line with the preferences of the government, revealed through the actual uses of budgetary funds, this report recommends a more focused role for the government in investment, which uses budgetary resources more effectively while allowing continued progress in the commercialization of the financial and enterprise sectors. A public investment program of 6-10 percent of GDP would appear appropriate and would include investments by all levels of government in administration, social sectors, most infrastructure sectors and initially a few competitive sectors which display dynamic externalities. This would result in roughly equal shares for local and central investments. The program would exclude the bulk of competitive activities, notably in light industry, construction and commerce. This does not imply that the entire financing of the public investment program would have to come from budgetary sources, although the gap between budgetary resources currently available for investment and public investment financing requirements would shrink considerably, reducing pressures for off-budgetary financing. The transition toward a more-focused role for the government in investment does not obviate the need for continued supervision of the use of state assets, however. Mechanisms and institutions need to be established to ensure the protection of the state's rights as shareholder, including the proper renumeration of its capital. Institutions and Process. It is recommended that a rolling medium term public investment program (PIP) be prepared that resembles the current annual investment program in terms of project and financing detail, but covers a 3-5 year period. However, the scope of the PIP would be more limited. Instead of planning investments of the entire state sector, the PIP would be limited to those projects that use government or government-controlled resources.  - xii - Every year the program should be updated and moved forward a year. The PIP should be presented to the State Council for approval and may also be submitted to NPC's consideration as an annex to the budget. SPC's functions would remain largely unchanged even though the scope of its interventions would be reduced: it would remain in charge of overall coordination for the PIP and its approval would be required for medium and large scale projects but the threshold would be increased. The Ministry of Finance (MOF) should become more involved in the management of the budget and strengthen its capacity for doing so. First, a more comprehensive investment budget should be prepared. Second, the distinction between capital construction and technical transformation expenditures should be eliminated. Third, responsibility for budget execution should be centralized in one department. While the allocation of expenditure responsibility by level of government appears reasonable overall, SPC and MOF should establish specific guidelines to determine which local government projects qualify for transfers from the center. Instead of substantial project specific funding flows from the center, it might be preferable to adjust the system of general transfers so that it better matches local spending responsibilities, perhaps supported by the provision of limited matching capital grants for specific purposes. Incomplete financial market reforms, a nascent capital market and the lack of transparency in fiscal accounts of both central and local governments make local government borrowing in China undesirable at this stage. However, China's authorities should consider a program of capital market and fiscal reforms that would in the future give local governments some access to capital markets. The authorities may wish to consider a multiyear fiscal plan (MYFP) to complement the PIP and further improve allocative efficiency for government resources. In particular, the MYFP would allow the budget to take into account the recurrent expenditure implications of investment projects included in the PIP and to consider the trade-offs between capital and current expenditures in a multiyear framework. A strengthened budgetary process would also obviate the need for earmarking. In the longer-run, when resort to offbudget resources is further reduced, the PIP may be subsumed under the MYFP, in line with current practice in most OECD countries. Finance. Budgetary funding should be limited to investment projects which are unable to tap commercial sources offinance. Even when government support is needed, it should be additional to, rather than supplanting, commercial financing whenever possible. The budget should contain full funding only for public goods with little or no potential for cost recovery. But, fiscal reform needs to be pursued to ensure that governments at all levels have adequate resources to assume their financial obligations with respect to public investments within their jurisdiction. In particular, there is a clear case for devoting additional resources to the social sectors so as to prevent the erosion of substantial past achievements in these areas, which are crucialfor the long-term sustainability of China 's growth objectives. Depending on the project, the government could leverage its resources with other funds-- including enterprise savings, foreign borrowing and domestic credit. If public investment projects cannot be fully funded from government-controlled sources, and are unable to attract commercial financing, aformal government loan guarantee can be a useful instrument to reduce the risk to the lender, especially a foreign lender. Because such guarantees create a potential  - xiii - liability to the government, they should be reflected in the budget and be subject to an overall ceiling. Reform offiscal extrabudgetaryfunds (FEBFs) requires distinguishing between the types of entities that benefit from them. SOUs that provide government services and rely predominantly on general budgetary allocations or on earmarked levies, taxes and surcharges should be considered part of government and integrated into the budgetary process. Earmarked taxes and surcharges levied on marketable products should ideally become part of the relevant prices. This would imply some loss of government control over investment resources and may be problematic in the short term, in view of the incomplete nature of enterprise reforms and constraints on alternative sources of investment funding for local governments. In the short- term, integrating FEBFs into the budget may require retaining earmarking in some cases. The state 's project-specific financing plan should be limited to the public investment program. Until appropriate mechanisms are developed for indirect monetary management, the authorities will have to rely on quantitative restrictions on credit. However, a shorter term objective should be to eliminate reliance on the financing plans (credit, bond and equity) for influencing the pattern of investment. This implies continued imposition of aggregate credit ceilings, which could be allocated across banks based on the growth of their deposits, but without direction of credit into specific uses. Given the limited scope for budgetary financing in the short term, uncertain prospects for rationalizing fiscal extrabudgetary funds, rudimentary capital markets and commercial bank exposure to term transformation risk, investment financing institutions, like SDB, may serve a usefulfimction during the transition to a more robustfiscal capability and more maturefinancial system. However, there is a need to clarify SDB's role and operating procedures and to safeguard its financial viability. * First, the authorities need to clarify the extent to which SDB should form its own investment agenda independently of the SPC. The report recommends that SDB be assigned specific policy objectives, that it be able to implement these objectives as it sees fit through its investment portfolio, and that it not be seen as a financing window for priority projects that fall outside its mandate. As envisaged, SDB would finance key infrastructure projects and support industrial policy objectives. However, SDB's autonomy, which is currently limited to the exercise of an (exceptional) veto on individual projects proposed by SPC, should be expanded in the future. In the medium-term, and once SDB has built strong independent project appraisal capability and established a solid track record, SDB could be given authority to select projects within its mandate, unencumbered by political preferences. * Second, although it is desirable to structure SDB's operations and institutional set-up so that its performance is subject to the extent possible to market discipline, SDB will remain a quasi-fiscal entity by virtue of its mandate and the ultimate assumption of liability by the state. In this context, setting up separate entities to channel hard and soft loans should be considered, along the lines of the World Bank Group (IDA and IBRD). Performance on hard loans could be subjected largely to market discipline while effectiveness of soft loans would be evaluated based on administrative criteria. * Third, SDB should establish rigorous project evaluation and selection criteria, clear approval procedures, and strict supervision practices. It would be in SDB's strong interest not to  - xiv - inherit a substantial portfolio of old investments, as this will make its financial position less transparent, may saddle the SDB with vested interests in new lending operations, and may burden the institution with costly but largely futile collection efforts. SDB should give consideration to incorporating incentives for loan collection in its agency contract with PCBC; in the medium term, competitive bidding for these services would further efficiency. * Fourth, interest rates on SDB's hard loans should reflect the full cost of funds and administrative expenses. Lending rates will contain an element of subsidy, however, to the extent that SDB benefits from a sovereign guarantee on its borrowing and its capital is not subject to remuneration. * Fifth, SDB should require adequate collateral or coguarantors for its loans; initiate collection procedures in case of nonpayment; provision for potential bad debts promptly and fully; and get its fiscal contributions (whether for capital or interest rate subsidies) in annual appropriations not tied to specific loans or projects. These appropriations must be made consistent with budget financing capabilities. At the same time, the scope of SDB's soft lending operations should strictly reflect the level of fiscal contributions, so as to prevent decapitalization of the bank. * Sixth, SDB's access to funding from commercial banks or capital markets should be stable but subject to explicit limits set by the government. In the medium term, the objective should be voluntary placement of SDB bonds; in the interim, bond rates should be set in relation to prevailing commercial lending rates of equivalent maturity. SDB bonds should carry a sovereign guarantee, at least in the short term when these bonds are still subject to administrative placement. Also, as it is unlikely that the government would allow a quasi- fiscal entity like the SDB to go under, even in the longer term it may be beneficial to grant an explicit sovereign guarantee upfront. * Finally, the SDB should not be allowed to mobilize deposits nor to fund loans directly from PBC credit. There is no reason for an institution of these characteristics to be involved in direct resource mobilization; rather, it should delegate this retail function to commercial banks and attract its resources wholesale.  D. CHINA - PUBLIC INVESrMENT AND FINANCE: MATRIX OF KEY RECOMMENDATIONS Objective Area Short term| Medium term Long term Reduce Role of the Limit government involvement in project Reduce government involvement in Government in planning, financing and approval to sectors with strategic sectors. Investment public goods characteristics-i.e. social sectors, public administration, most infrastructure sectors and some strategic industries with dynamic externalities. Improve Public Public Establish a multiyear (3-5 year) rolling PIP, Extend PIP coverage; eliminate annual Incorporate PIP in multiyear fiscal Investment Investment initially for all key state projects. investment program and key state plan. Management Program (PIP) project designation. Define criteria for inclusion in PIP; increase Present PIP to the State Council and to project approval threshold. NPC as an annex to the budget. SPC to be in charge of overall coordination for Eliminate distinction between capital Revise SETC's mandate to focus on PIP and approval for large projects. construction and technical promoting 'private" investments. transformation projects. x Budget Continue to provide budgetary grants to sectors Initiate a multiyear fiscal plan (MYFP) Present MYFP to NPC's with limited potential for cost recovery. to complement the PIP. consideration. Provide capital contributions and interest subsidies to SDB. Consider loan guarantees to attract commercial Set a ceiling on guarantees and include funds to projects in the PIP. a provision for contingent claims in the budget. Establish explicit criteria for central government Establish a general intergovernmental Implement general grants scheme support for local projects. grants scheme that takes into account supplemented, if needed, by limited capital needs of local government matching grants for specific functions. purposes. Extrabudgetary Classify fiscal extrabudgetary funds by nature of Incorporate into the budget earmarked Restrict use of earmarking. Funds recipient institution. funds for government services.  D. CHINA - PUBLIC INVESrmENT AND FINANCE: MATRIX OF KEY RECOMMENDATIONS Objective Area Short term Medium term Long term Incorporate surcharges on marketable products into relevant prices and tariffs. Promote Financing Plans Reduce coverage of credit plan, move toward Continue reducing investment credit Eliminate the credit plan, with the Commercialization aggregate credit ceiling for investment, with allocation, in line with the shrinking MYFP and the financial sector of Financial project-specific credit allocation only for the PIP. scope of the PIP. assuming respective responsibilities. Sector Institute disclosure requirements for enterprise Institute a global quota for enterprise Eliminate global quota. bond issues. bond issues with project-specific allocation only for the PIP. Improve disclosure for equity issues. Institute a global quota for equity issues Eliminate global quota. with project-specific allocation only for _____________ ~~~~~~~~~~~~~~~~~~the PIP. Ensure Adequate Policy and Issue detailed implementing regulations based on x Financingfor Institutional SDB's charter. < Public Framework Investment: Role Limit SDB operations to projects with no Increasingly co-finance projects with Transfer "soft' loan window into of SDB prospects for commercial funding due to low conmmercial banks. MOF. Either disband SDB or tum financial (but high social) profitability, high risk it into a commercial venture. or long gestation. Establish "hard" and 'soft" loan windows and formulate lending criteria for each. Set annual limits for SDB lending consistent with its policy function and the development of commercial banking sector. Establish clear criteria for lending to strategic Reduce SDB involvement in strategic industries, for maintaining financial discipline in industries. protected industries, and for phasing out SDB ftnancing.  D. CHINA - PUBLIC INVESTMENT AND FINANCE: MATRIX OF KEY RECOMMENDATIONS Objective Area Short term Medium termt Long term SPC/SETC and SDB to confer on SDB's loan Increase SDB's autonomy to identify porfolio with veto power for SDB. and finance part of the PIP in line with its mandate. Clarify SDB's relations with SIDC and ensure SDB's control over its subsidiary. Agency contract with PCBC to incorporate Introduce competition in selection of incentives for loan collection. agency relationship. Liability Fiscal contributions (capital contributions and Consider tapping equity market for new Management interest subsidies), to be disbursed quarterly but capital if SDB's performance merits. not on a project by project basis. Annual interest subsidies to cover difference between cost and uses of SDB's funds to prevent x erosion of its capital. Extend an explicit sovereign guarantee on SDB Evaluate need for continued sovereign borrowing. backing. Set SDB bond rates in relation to commercial Introduce voluntary placement of lending rates for loans of equivalent maturity. bonds; extend maturity of bonds to reduce term transformation risk. Refrain from direct PBC financing of SDB's Restrict indirect financing through operations. discounting of SDB paper. Maintain prohibition on direct resource Review scope for bond issuance mobilization from the public. directly to the public. Asset Set up the opening balance sheet for SDB and Evaluate the quality of assets acquired Management clarify the status of policy loans made in the past and make appropriate adjustments to by specialized banks. Preferable not to transfer balance sheet. these assets to SDB.  D. CHINA - PuBuC INVSmENT AND FINANCE: MATRix OF KEY RECOMMENDATIONS Objective Area Short term Medium term Long term Provision for bad debt and adequately account for interest is suspense. SDB Staff and Recruit new staff with financial background. Improve risk and liquidity management; Tralig Needs upgrade fmancial appraisal and project Set up a management information system. supervision capability. Promote Private Policy Set up a transparent regulatory Fliancingfor Framework framework for "private" participation Infrauacnare in infrastructure. Invesgments Eliminate policy induced risks for investors-e.g. on prices/tariffs, access to foreign exchange, uncertainty on permissible rates of return. Flnnncinlg Consider promoting the establishment x of specialized infrastructure investment funids which would mobilize domestic equity financing.  1. BACKGROUND AND TRENDS IN CHINA'S INVESTMENT A. INTRODUCTION 1.1 Over the last decade, China has experienced high rates of growth, spurred largely by an increasing savings and investment effort. In 1994, total investment in fixed assets stood at 36.4 percent of GDP, up from 23.7 percent in 1982. With the exception of the retrenchment in 1989- 90 when investment levels declined by as much as 7 percent of GDP, this represents a steady increase in the rate of capital accumulation. Despite such impressive levels of investment, however, a number of infrastructure bottlenecks emerged during the recent growth spurt. The sustainability of high levels of growth in China depends in large part on the country's ability to convert its remarkably high domestic savings into economically profitable investments. Even the more modest growth targets of 8-9 percent for the coming decade will require massive investments, particularly in infrastructure but also in the social sectors. 1.2 The economic incentive structure facing investors has changed substantially, in particular through price reforms and the opening up of the economy to foreign trade and investment. While most of the Chinese economy now operates on a market basis, the investment system remains largely unreformed. The current investment system evolved out of the former planned economic system and continues to bear the marks of that system, including its shortcomings. Investment by state-owned units is very large, and shows no tendency to decline; despite ongoing decentralization, central government investment has remained substantial; the government's investment effort is too dispersed to have sufficient impact on sectors with traditional public goods characteristics; the government continues to influence all investment decisions through its investment approval mechanisms and the credit plan, thereby interfering with the assumption of greater autonomy by enterprises and lenders alike; the risks of investment remain socialized and the cost of capital is largely negative in real terms. 1.3 The current investment system can best be seen as a pragmatic adaptation to the challenges presented by economic reform and rapid economic growth. In some respects, that pragmatic response has been successful, especially in sustaining fairly high levels of infrastructure investment overall. Infrastructure investment represented almost 30 percent of state investment or some 6.5 percent of GDP in 1993; preliminary data indicate that it will be a slightly larger share of GDP in 1994, mostly due to surging investment in transportation and telecommunications. This compares favorably with average infrastructure investment levels of 4 percent of GDP for developing countries.' China's achievements remain considerable also when (physical) indicators are used to evaluate the stock of social and economic infrastructure in a set of comparator countries. Infrastructure investments ranged from 40 to 60 percent of public investment and 2 to 8 percent of GDP for a group of twenty developing countries analyzed for the 1994 World Development Report.  1.4 But at the same time, the failure up until the present to reform and restructure the investment system has meant a continuing inability to reap significant efficiency gains from an improved investment and financial system. Performance indicators do not show any improvement in the effectiveness with which invested resources are converted into new fixed assets; these remain at the levels of the unreformed communist economies of the 1980s. The government remains starved for resources to finance an overly ambitious investment program, and in its attempts to generate resources, puts pressure on the country's financial system, distorting the reform and healthy development of that sector. Moreover, the partial reforms in the enterprise and financial sectors interact with the unreformed investment system and inappropriate investment incentives to generate significant macroeconomic imbalances that tend to lead the Chinese economy into stop-and-go cycles. 1.5 Greater market orientation in the economy as a whole requires and depends on fundamental changes in the role of the government. Increased devolution of economic decisions to enterprises is important for efficiency. Equally important, however, is an appropriate legal, social and economic infrastructure which promotes growth while safeguarding long-run sustainability. The process of separating government from enterprises started in China in 1984 with fiscal reforms but remains one of the largest challenges on the government's reform agenda. It is indicative of the ambiguity of enterprise-government relations that the Chinese statistical system does not distinguish between investments of state-owned enterprises and governmental agencies.' Essential for this separation is the delineation of an appropriate role for the government in investment, the establishment of appropriate institutions and instruments to perform that role and the development of noninflationary sources of finance. 1.6 The Chinese investment effort will have to remain strong in order to maintain high levels of economic growth. However, investment reforms can generate efficiency gains which would allow, at the same time, for more rapid increases in per capita consumption, and in government expenditures targeted at sustainable development. The shortcomings of the current investment system are widely recognized in China. Current proposals for investment reform represent an important step forward but need to be pursued further. This report is intended to contribute to the ongoing reform process. It has a strategic and institutional focus and should constitute a framework for future work which would deepen the analysis through more detailed sectoral treatment and widen the scope through examination of current public expenditures. The report starts with a review of trends in investment in the remainder of this chapter and focuses in Chapter 2 on the issues raised by the current investment planning and finance system. Chapter 3 concludes the report with the presentation of a framework for public investment. B. TRENDS IN INVESTMENT 1.7 This section highlights some of the important trends in investment flows over the last decade. In particular, the discussion includes an analysis of ownership patterns, sources of financing and sectoral composition. Chinese data report investment by ownership, funding source, type of investment (see Box 1.1) and sectoral composition; sectoral data are quite detailed for the state sector but highly aggregate for the economy as a whole.3 The analysis in 2 They are both classified under the category state-owned unit (SOU) investment. 3 The Statistical Yearbook does not report sources of financing by sector or by level of government. The mission was able obtain some additional, if inconsistent, data from the SPC Investment Institute as part of a background paper for this report.  - 3 - this section is on global investment patterns, with particular emphasis on the state sector. Public investment-as distinct from state investment-is examined in the next section. Ownership 1.8 Chinese investment data report investments by state-owned units (SOUs), collectively- owned entities and individuals. SOUs include enterprises owned by the various levels of government as well as governmental agencies or units. Their investments are subdivided into capital construction, technical transformation or other investments (see Box 1 . 1). Collective and individual investors are either urban or rural. Joint ventures and shareholding enterprises constitute yet another category of investors which until recently was included in the state sector. Box 1.1: CHINESE INVESTMENT TERMINOLOGY Investment is divided into "capital construction," "technical renovation," "other", and "commodity housing." The boundary between these different categories of investment is extraordinarily vague. In fact, the divisions correspond clearly to institutional differences in the way investments are managed, and only secondarily to the nature of the investments themselves. "Capital construction" refers to new projects or major expansions of existing firms that involve significant construction. In practice, the capital construction plan is managed by the State Planning Commission and, at the local level, by Provincial Planning Commissions. The Planning Commission exerts control over capital construction investment in two ways: (I) it approves individual projects and (2) it has predominant influence over the allocation of resources to specific projects or to sectors and regions. "Technical transformation" (or renovation, replacement or renewal investment) consists primarily of investments carried out by existing enterprises, for which civil works constitute less than 30 percent of total project costs. Initially, this category of investment was established to cover investments made by enterprises out of their own financial resources-retained depreciation funds and, subsequently, retained profits. Thus, this type of investment was distinguished by funding source. However, with the ongoing reform of the investment system, and the accompanying diversification of investors and funding sources, the distinction is no longer clear. Both enterprise funds and bank loans are now significant sources of technical transformation investment. Indeed, 41percent of technical transformation was funded by domestic credit in 1992 (compared to 28 percent of capital construction); while various kinds of retained funds (not necessarily enterprise retained funds) accounted for 49 percent of technical transformation and 41percenr of capital construction investment. In the current environment, technical transformation investments are not necessarily small in size, nor are they always limited to existing facilities. Technical transformation investments are concentrated in industry: 74 percent of the total in 1992, compared to 48 percent of capital construction. Moreover, management of technical transformation investment is carried out not by the Planning Commission, but by the State Economics and Trade Commission (SETC). In general, the SETC's surveillance of technical transformation investment is less intrusive than the SPC's oversight of capital construction. Since projects are on average smaller and more dispersed, and since the organizations carrying out the investment are more likely to be funding them out of their own resources, the SETC does not attempt to control them as closely. Moreover, the banks that lend to enterprises for technical transformation investments have substantially more operational autonomy than is the case with capital construction lending. "Other" investment simply refers to investment that the Chinese government does not attempt to restrain. This category includes certain specific categories of earmarked funds collected and used in designated fashion. In practice, a few funds account for the bulk of this category. Most important are oilfield depletion allowances (69 percent of the total); highway maintenance funds (22 percent) and mine depletion allowances (6.5 percent) for coal, iron ore and other minerals. These funds are simply left to the discretion of the managing agency. Because they accrue primarily to the centralized petroleum industry, most "Other" investment (72 percent) is carried out by the central govemment. The government's attitude is that in these cases, the more investment, the better. Note that "Other" investment bears no relationship to the category of "Other" in funding sources. Most "Other" investment is financed by retained funds. Since 1990, the govenmment has also separately collected data on "commodity housing." Before 1990, housing investment is classified according to the sector of the organization or enterprise that carried out the investment. (In other words, housing built by steel mills is classified as steel investment.)  -4 - 1.9 Dominance and relative Figure 1.1 inefficiency of the state sector: Despite the growing importance of the CHINA: Fixed Investment by Ownership nonstate sector in the economy, state- (percent) owned units continue to account for 75 7-- the bulk of investment at a relatively stable share of two-thirds (Figure 1.1). 60 An analysis of the industrial sector 45 confirms the dominance of the state 30 sector in investment despite a steady 15 decline in its share in total industrial output (Table 1.1). In 1982, the state sector accounted for 75 percent of 8 sou, industrial output and some 87 percent ., of industrial investments. By 1992, - , _ _h., the state sector accounted for less than Note: "Other" investors were included in SOU category one-half of total industrial output but prior to 1993. continued to absorb three-quarters of Source: China Statistical Yearbook. total investment in the sector.5 Table 1.1: SHARE OF THE STATE SECTOR IN 1.10 The sheer size of the state investment INDUSTRIAL OUTPUT AND INVESTMENT effort is worthy of note (22.4 percent of GDP (in percent) in 1993) and raises issues of crowding out of nonstate investments. Equally important, 1i982 19872 .1992 however, are the implications of these Output 74.4 59.7 48.1 numbers for the efficiency with which capital Investmnent 86.5 80.2 74.3 is utilized by state-owned units (Figure 1.2). Two mitigating factors are that state-owned Source: China Statistical Yearbook, various units are likely to engage in more capital- issues. intensive activities, and that their output is more likely to be priced at below market levels. However, in 1993, the state sector accounted for 43 percent of industrial employment- same as its share in industrial output-even while absorbing the bulk of investment resources. Also, by the end of 1992, prices of 90 percent of all consumers goods (in terms of sales value) and 80 percent of industrial raw materials had been deregulated. 1.11 It would appear, therefore, that state industrial investment is much larger than the size of the state sector would warrant. Alternatively put, the state industrial sector appears to use investment resources less efficiently than the rest of the economy. Analysis based on fixed asset 4 The decline in 1993 (to 61.5 percent) is due to a change in statistical reporting; investments in which the state has a stake (particularly Sino-foreign joint ventures), which were previously included in the state sector, now constitute a new category of investors ("other"). Information is not available to reconstruct the series on the basis of the new convention but the 1993 figure would have to be 70.5 percent to be comparable to earlier years. In 1994, the figure was even higher at 71.3 percent. 5 There is a problem with comparability of the share of the state sector in investment and output as joint- venture enterprises are excluded from the output, but not the investment, of the state sector. Correcting for this (by including the industrial output of these enterprises in the state sector) would reduce the magnitude of the decline in the state share of industrial output; the latter would go from 75 percent in 1982 to 55 percent in 1992.  - 5 - to output ratios at the subsector level supports this conclusion. These ratios are higher in the state sector for all 40 industrial subsectors for which data are available (Tables 1.2 and Al.1). Table 1.2: CHINA'S INDUSTRIAL ENTERPRISES: FIXED ASSETS TO NET OUTPUT RATIOS FOR THE STATE AND NONSTATE SECTORS, 1993 Original Value of Original Value Original Value Fixed Assets of Fixed Assets of Fixed Assets over Net Output of over Net Output of over Net Output of Industry (All) Industry (State) Industry (Nonstate) National Total: 2.0 2.6 1.2 Grouped by Light & Heavy Industry Light Industry - 1.5 1.9 1.2 Heavy Industry - 2.3 2.9 1.2 Selected Sectors Coal Mining & Processing 3.7 4.4 1.1 Food Processing 1.4 1.6 1.0 Food Manufacturing 1.7 2.2 1.3 Beverage Manufacturing 1.7 1.8 1.4 Tobacco Processing 0.5 0.5 1.0 Textile Industry 1.8 2.4 1.4 Garments & Other Fiber Products 0.8 1.2 0.8 Furniture Manufacturing 1.3 2.4 1.2 Papermaking & Paper Products 2.7 5.6 1.5 Cultural, Educational & Sports Articles 1.2 1.5 1.1 Petroleum Processing & Coking Products 2.1 2.2 1.2 Raw Chemical Materials & Chemical Products 2.5 3.4 1.2 Medical & Pharmaceutical Products 1.4 1.6 1.2 Chemical Fibers 3.3 3.8 2.9 Rubber Products 1.4 1.6 1.2 Plastic Products 1.8 2.7 1.6 Metal Products 1.1 1.8 1.0 Ordinary Machinery Manufacturing 1.6 2.2 1.0 Transport. Equip. Manuf. 1.4 1.8 0.9 Electric Equip. & Machinery 1.2 1.7 1.0 Electronic & Telecommunications 1.6 2.2 1.2 Electric Power, Steam & Hot Water Production & Supply 6.1 6.1 6.4 Gas Production& Supply 14.2 14.7 6.3 Tap Water Production & Supply 5.2 5.3 4.4 Source: Statistical Yearbook, 1993 and Annex Table Al. 1.  - 6 - Figure 1.2 CHINA: Indusbial Investnmnt-Output Ratios CHNA: Industrial Labor-Output Raidoe 16 0 25 0 . . . ..... .......... .. .. ............. ... .... ..... . . .250..... .... .._. ....____ ... 14.0 C- - X t 2.0 .. 12.0- 29 s tA}10. _0- 00 , 00 ..... State -~-nott-sCawte 1 i.L .- _ nS Source: China Statistical Yearbook, various issues. 1.12 Strong central government presence. There has been some decentralization of investment to lower levels of government, but this remains limited especially given the inclusion of enterprise investments in the "local" category (see Box 1.2). The share of central government projects declined from 46.6 percent in 1978 to 37.7 percent in 1993, but remains substantial6 (Figure 1.3). In 1978, investment in central government projects amounted to 8.7 percent of GDP, and in 1993 it was 7.9 percent of GDP. During the same period, local govemment investment increased from 9.9 percent of GDP in 1978 to 10.9 percent in 1992 before climbing to 13.1 percent in 1993. Among central government investments, surprisingly, the share of technical transformation projects increased while capital construction projects declined in importance, accounting in 1993 for only one-fourth of state investments, down from 40 percent in 1978. Box 1.2: CENTER VS LOCAL The Category of"state" investment in China includes both central and local govemment investment. All state investment is classified according to the level of subordination of the enterprise with the primary responsibility for the investment project. Local projects are those subordinate to the provinces, municipalities, prefectures or counties. Projects can have financial participation from more than one level of govemment- thus, a province can contribute funas to a central government project, and is often called upon to do so when the project benefits a particular province. For example, most electricity projects are central, but the central government generally requires the provincial govemment where the project is located to contribute funds. However, for data collection purposes, all the expenditure on such a project is classified as central. The categories of "central" and "local" are not symmetrical. Central govemment investment which is coordinated through the State Planning Commission, generally reflects central govemment policy, and is roughly equivalent to govemment investment in other developing countries. By contrast, local investment in state-owned units is the aggregate of investment by local govemments as such (for example, urban infrastructure investment), and of state-owned enterprises (SOE) nominally under the authority of local govemments. In practice, many SOEs have gained considerable autonomy in recent years, and their activities correspond to that of parastatals in other developing countries. 6 The 1993 figure excludes housing investment (6 percent of total state investment) as there is no information available on the breakdown by level of govemment.  Figure 1.3 CHINA: Share of Central Government in State Investment 50.0 450_ 40.0. 35.0 20.0 5.0 - 0.0 I l 1982 1986 1988 1990 1992 ---- central -in- cc - f Source: Various Statistical Yearbooks, Statistical Materials. Central share of "other" investment is estimated for 1980-85 and 1990-94, based on data for 1986-89. Sources of Finance 1.13 Chinese statistics separate funding sources into five categories: budget, domestic credit, foreign capital, own-funds ("self-raised", retained, or extrabudgetary funds), and other. Chinese investment, both in aggregate and in individual projects, relies on a combination of funding sources. The balance of these sources has been changing over time, with a trend decline for the share of budgetary funds, and increasing reliance on domestic credit and own funds (Figure 1.4). 1.14 Dwindling budgetary resources for investment. China's large investment effort has been sustained despite a steady decline in government budgetary contributions. Budgetary outlays for investment which financed almost the full arnount of state investment in 1978 have since declined steadily as a share of GNP. In the early years of reform, the decline was due to increased enterprise autonomy as SOEs were no longer required to remit all profits to the budget. In later years, however, reduced budgetary contributions were the consequence of a shrinking tax base (as a percentage of GDP). Increased competition that reduced monopoly profits of SOEs contributed to this decline but systemic problems have become increasingly more important. These include increasing resort to legal and illegal exemptions and a weak tax administration which is unable to capture into the tax net a growing number of enterprises, in particular in the nonstate sector.  - 8 - Figure 1.4 CHINA: Sources of Investment Financing 28.0 24.0 - -- - - - 20.0 +-+ --+ +-+-r | ~~~~~1982 1986 1988 1990 1992 l l~~~~ Budget .Donustic lbansX 120 -.-O-er -+ _ Fore-n - -estn-nt- Source: China Statistical Yearbook Various Issues. 1.15 Budgetary and investment data are consistent in showing this steady decline (see Figure Al. 1). However, investment expenditures in the budgetary accounts are substantially greater than the figures reported in the investment statistics, which are compiled based on information collected at the project level. Although budgetary data are likely to be more accurate regarding the aggregate level of government investment financing, most of the analysis in this report is based on the investment statistics, for internal consistency and details on sectoral composition. There are two reasons for the discrepancy: the definitions of the two concepts vary in ways which would make the investment data smaller; and some investments funded by the budget are misclassified by the recipient investment.' Judging by the investment data, budgetary funds amounted to only 1.5 percent of GDP and accounted for only 6 percent of state investment in 1993. Information from the Ministry of Finance (MOF), on the other hand, puts budgetary funding of investment at 3.9 percent of GDP, or 17.3 percent of state investment in the same year. In either case, there appears to be a substantial mismatch between the large government role in making investment decisions and allocating investmentfunds, on the one hand, and the limited importance ofgovernment financial resources, on the other. 1.16 Increasing reliance on credit and own funds. Bank credit for fixed investment has been increasing steadily throughout the reform era. Fueled by high levels of savings, the banking system has played an increasingly important role in transferring household surpluses to the enterprise sector, often in ways that privilege SOEs, and especially state industrial enterprises. 7 The investment data refer to completed investment-i.e., to bricks laid and machinery installed; the budgetary data refer to allocations of money. Thus, budgetary allocations transferred to the account of investing units show up as completed investment only after a time lag, and with a certain wastage. Since investment grows annually, the investment data will always be less than the budget data. The misclassification is as follows: the budget appropriates funds which are disbursed by PCBC as repayable, interest-bearing loans. From the standpoint of the individual investment project, these may often be classified as bank loans, even though they are budgetary. In a similar fashion, foreign capital borrowed by the central authority and disbursed through the budget may sometimes be classified as "foreign capital" rather than budgetary funds.  - 9 - 1.17 Several data series are available on fixed investment lending (see Box 1.3). While these differ substantially in the scale of investment credit, they are consistent in showing increasing reliance on domestic credit for fixed asset investment. Domestic credit, including bonds, financed 24 percent of investment in 1993-equivalent to 9.3 percent of GDP, up from 3.4 percent in 1982. The bulk of this credit takes the form of bank lending. Available information indicates that officially-approved bond issues did not exceed one-third of domestic credit for fixed asset investment in 1992, up from 14 percent in 1987.9 Box 1.3: CREDIT FOR INVESTMENT: WHAT IS THE OUTSTANDING STOCK? There are various sources for data on investment credit which are difficult to reconcile. Domestic loans for investment, as reported in the Statistical Yearbook, include govemment-approved enterprise bonds in addition to borrowing from the financial system. At the end of 1992, there were some 104 billion Yuan of enterprise bonds outstanding, including those issued by the central govemment and the state investment corporations (SICs). According to financial data, state banks had a total of 392 billion Yuan worth of fixed investment loans on their books as of the end of 1992. These figures cover only a part of the outstanding liabilities to financial institutions. There are substantial loans from nonbank financial institutions which fall into two categories. The first consists of rural and urban credit cooperatives, which had between them 196 billion Yuan in loans to nonagricultural enterprises, but do not provide breakdowns into fixed and working capital investment. The second category consists of state-owned or joint stock investment and insurance companies. None of these publish data on fixed asset investment. Most of these institutions are of moderate size, but taken together they probably had loans against fixed asset investment projects of 30-40 billion Yuan at the end of 1992. Nor can it be presumed that the available figures for state banks cover all state bank lending to fixed investment projects. For example, during the first half of 1992, the banks lent 15.9 billion Yuan to investment projects in order to allow them to pay off overdue bills (as a way to clear up the problem of interenterprise debt chains); there are many kinds of special loans, a significant portion of which finance fixed investment; and anectodal evidence suggests that part of the quota for working capital loans is diverted for fixed investment lending during periods of credit tightening. It is extremely unlikely that all of these loans are included in the aggregate fixed investment lending figure.' Total long-term credit outstanding probably exceeds 600 billion Yuan. Zhongguo Jinrong Nianjian 1993 (Almanac of China's Finance and Banking 1993), pp. 356-57, 373, 424, 438, 457. 1.18 Investment credit goes primarily to the state sector, and in particular to state-run industry. The state sector overall claimed 66.6 percent of fixed investment lending in 1993, larger than its share of total fixed investment. During 1992, 71 percent of state capital construction and technical transfornation loans went to industry, again larger than the 57 percent industrial share of that investment (excluding other and commercial housing). Thus, in both 1992 and 1993, about half of all bank credit for fixed investment went to state-run industry, even while state industry accounted for less than 20 percent of GDP."' s Investment data place domestic credit for investment, including officially-approved enterprise bonds and borrowing from the financial system, at 293 billion Yuan in 1993. For the same year, financial institutions reported net investment lending of only 127 billion Yuan. The analysis in this section is based on data collected at the project level. 9 This assumes that only a small proportion of treasury bonds were used to finance investment. '