China - The Chinese economy : fighting inflation, deepening reforms

ESw r | R o : t .~~~~~~~~~ z ES U0 z X* o o~~~~~~s 4~~ *-I 0,   A WORLD BANK COUNTRY STUDY The Chinese Economy Fighting Inflation, Deepening Reforms Tbe Wbrld Bank WVbiVSng/on, D. C.  Copyright (C 1996 The International Bank for Reconstruction and Development/THE WORL) BANK 1818 1H Street, N.W Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing Mav 1996 World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analy- sis by the 13ank of the economic and related conditions of its developing member countries and of its dialogues with the gov- ernments. Some of the reports are published in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. 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ISSN: 0-0253-2123  Contents Acknowledgments v Overview vii Part I Recent economic developments I Chapter I Stabilization with growth 3 Growth, inflation, incomes, and employment 3 External trade and the balance of payments 6 Monetary policy 9 Public finance 10 Conclusion 11 Part 11 Structural reforms for rapid, sustainable growth 13 Chapter 2 Reforming state enterprises: the unfinished agenda 15 The problem 15 The government's response 17 Experimentation by local governments 18 The unfinished agenda 19 Chapter 3 Financial sector reforms: major issues and policy options 25 Recent progress in financial sector reforms 25 The credit plan 28 Interest rate policy 29 The central bank 32 State commercial banks 34 Policy banks 35 Nonbank financial institutions 36 The capital market 37 Chapter 4 Reforming public finances 39 Expenditure needs 39 Mobilizing revenues 42 Intergovernmental resource transfers 43 iii  Annex I a Matrix of proposed financial sector reforms 47 Annex I b Matrix of proposed state enterprise reforms 51 Annex 2 Reforming public finances for sustainable development 53 Education and health 53 Poverty alleviation 55 Environment 55 Infrastructure 56 Contingent liabilities 56 Budgetary expenditures revisited 57 Mobilizing revenues 58 Intergovernmental fiscal regulations 61 Annex 3 Note on the calculation of the public sector deficit 65 Borrowing from the public and nonstate sector 65 Foreign financing 65 Borrowing from the domestic banking system 65 Annex 4 Technical note on the decomposition of China's growth 67 Methodology 67 Data requirements 68 Results 69 Annex 5 Statistical annex 71 TiIL CIIINLSIS LC(ONOMY: 1I1611TING !NILAHOION, DLLPLNIN.( HLIFORMS iv  Acknowledgments This report was prepared bv a team led bv Vikram Nehru Exchange Control; Qiu Xiaohua, Chief Economist, State and comprising V7argha Azad, Bert Hofman. Aart Kraay, Liu Statistical Bureau; Li Weicheng, Professor, International Dusheng, Tamar Manuelyan Atinc, Zhou Xiaobing, and Trade Research Institute, Ministry of Foreign Trade and Eduardo Borensztein (IMF). The team visited China in Economic Cooperation; and Li Keping, Division Chief, November 1995. Harry Broadman, Hongjoo Hahm, Deena Macro Systems Control Department, System Reform Khatkhate, Surinder Malik, and Richard Newfarmer also Commission. The mission would also like to thank Tang contributed to the report. The peer reviewers were Pradeep Sining, Deputy Director, Foreign Debt and Investment Mitra, William Easterly, Nicholas Lardy, and Linda Koenig. Department. State Administration of Exchange Control; The WXbrld Bank team benefited from fruitful discus- Zheng Jingping, Deputy Director, Comprehensive sions with many government officials, who were generous Department, State Statistics Bureau; Li Boxi, Deputy with their time and knowledge. The mission is especially Director, Development Department, Development grateful to the members of the counterpart team, which Research Center: Wang Huijiong, Vice President, Academic included Gao Jian, Director, State Debt AManagement Committee, Development Research Center; Ding Department, Ministry of Finance; Ding Xianjue, Director, Ningning. Director, Enterprise Department, Development Comprehensive Department. Ministry of Finance: Pan Research Center; Li Shantong, Deputy Director, Xiaojiang, Deputy Director, World Bank Department, Development Department, Development Research Center; Ministry of Finance; Xu Jiatong, Director, State Admin- and Wang Weixin, Comprehensive Division, Budget istration of Taxation; Jiang Qiangui, Director, Enterprise Department, Ministry of Finance. Mei Hong, World Bank Department, State Economic and Trade Commission; Wlu Department, Ministry of Finance, coordinated arrange- Xiaoling, Deputy Director General, State Administration of ments on the government side. v   Overview F or the first time since economic reforms were initi- The pressure on monetary policy was eased by a reduction ated in 1978, the government cooled an overheated in the aggregate public sector deficit and a shift toward non- economy without stalling growth. But keeping inflationary sources of finance. The key reason was stricter growth high and inflation low will be difficult and will controls on state enterprise investment. The government bud- require maintaining the momentum of economic reforms get deficit contracted only marginally as a share of GDP to increase the efficiency of investment, while moving to Underlying this, however, was a continued relative decline in indirect techniques of macroeconomic management. government revenues, which slipped to 11.3 percent of GDP Of significance was the increased reliance on noninflationary Stabilization with growth sources of deficit finance, especially borrowing from the pub- lic (using treasury bonds). This underlined the government's China's remarkable success in lowering inflation to below resolve to bring inflation under control. 15 percent in 1995 while keeping GDP growth above 10 Looking ahead, the government is in a good position to percent was accomplished through a judicious combination keep inflation below the target rate of 10 percent a year in of administrative measures and macroeconomic policies. 1996 while maintaining GDP growth in the 8-9 percent Good weather helped too; grain output reached record range. But this will still require skilled macroeconomic man- levels (465 million tons), pushing agricultural growth to 4.5 agement. Inflation could accelerate if credit expands prema- percent, raising real incomes in rural areas, and relieving turely, especially since prices were administratively repressed upward pressure on food prices. to some extent in 1995, and because of renewed strength in Stabilization of the domestic economy was accompa- the growth of investment and industrial production in the nied by further improvement in the external accounts. The last quarter of 1995. These considerations warrant a cautious trade surplus reached USS17 billion in 1995, and the cur- stance on monetary policy in early 1996, although room for rent account surplus expanded to 2 percent of GDP (after relaxation may appear as the year progresses, especially if being in deficit just two years before). Inflows of foreign inflationarv pressure from the external account recedes with direct investment climbed to US$38 billion, and foreign a slowdown in export growth. exchange reserves exceeded US$73 billion by year's end (equivalent to seven months of imports). High reserves and Structural reforms for sustained growth continued strength in exports eased the need to borrow with stability abroad. China's debt indicators improved further, reinforc- ing its strong credit standing in international markets. In the medium term, sustaining growth and maintaining sta- Broad money maintained its rapid expansion in 1995 on bility will require continued progress in structural reforms. the strength of rising foreign exchange resenres and higher- Efficiency gains from economic reforms have played an than-expected growth in domestic credit, as state commer- important part in China's impressive growth performance cial banks found new ways to circumvent the credit plan. since 1978. Harvesting these gains will be as important in the Despite this, inflation continued to fall. Contributory fac- future, if not more so. tors to the slowdown in inflation were a trend decline in the To do this, the government will need to maintain the velocity of broad money, weaker growth in narrow money, momentum of reforms in two strategic directions. The first and enhanced price surveillance and higher subsidies at the would place greater reliance on market forces, with an retail level, which moderated the price increases of essential emphasis on state enterprises and the financial sector. As commodities. banks and enterprises become more responsive to market sig- vii  nals, indirect macroeconomic management will become more * Accelerate the transfer of pension, health, and education effective. This, in turn, will ease the phaseout of administra- obligations from state-owned enterprises to government author- tive controls, further enhancing productivity growth. The sec- ities. It would be difficult to liquidate, sell, merge, or ond would stress restoring the health of government finances restructure enterprises if they were still required to meet by raising government revenue as a share of GDP and shift- these social expenditures. Pilot programs to transfer such ing the focus of government expenditure policy toward such expenditures to municipal authorities need to be accelerat- priority areas as health and education, poverty reduction, ed. At an appropriate point, these could be merged with infrastructure development, and environment protection. the national pension and health program. * Further promote comipetition to encourage greater efficiency State enterprise reform in state enterprises. Of importance would be the reduction of interprovincial and international trade and investment bar- There is virtually complete agreement within China that riers. Lower foreign trade and investment barriers would state enterprise reform is of the highest priority. State have the added advantage of strengthening China's case for enterprises absorb a disproportionately large share of the joining the World Trade Organization (WTO). country's resources; they have also become a drag on In implementing these policies, the government will growth and employment creation. need to consider the specific needs and circumstances of The government's enterprise reform program operates at different groups of state enterprises by: two levels: improving economic performance through Using competition and governance policies, not subsidies, to stricter market discipline and developing better governance foster the efficient development of the Central Government's within firms to improve productivity. State-owned enterpris- priority 1,000 large state enterprises. These state enterprises es are being disciplined by the market through tough com- and enterprise groups are expected to eventually form the petition created by trade liberalization and the proliferation core of China's modern enterprise system. An appropriate of nonstate enterprises. At the same time, financial support way to improve their efficiency would be to provide these for state enterprises is being cut back. The combination of enterprises greater management autonomy and better gov- these two pressures is encouraging enterprise restructuring, ernance structures, expose them gradually to domestic and especially at provincial and municipal levels. international competition, diversify their sources of The stated policy of the government is to strengthen state finance, and apply better regulations. In cases where the enterprises and maintain their position as the mainstay of the government feels compelled to provide subsidies, these economy. To focus its efforts, the Central Government should be limited, time-bound, and channeled through the recently selected 1,000 large state enterprises as priority for budget rather than the financial system. reform and development. For the other state enterprises, a * Improving the efficiency of 14,000 large- and medium-size variety of approaches to reform are undenvay in the form of industrial enterprises by diversifiing ownershzp, reconfiguring experiments at the provincial and municipal level. operations, restructuring debt, encouraging mergers and consol- Looking ahead., the task of improving the efficiency and idations, and, where necessary, by liquidating. Marginal loss- competitiveness of China's state enterprises is expected to be making firms that are inherently viable financially could be complex and difficult. This report recommends three under- restructured by shedding labor, investing in new equip- lying sets of policies that provide a framework for state enter- ment, and reengineering finances. Debt restructuring prise reforms in the future. For all state enterprises, the gov- should occur only when a corporate strategy is agreed ernment should: between the bank, the (local) government, and enterprise *Implement programs to improve internal governance, diver- management, and on the strict understanding of no future sify ownership, and lower budgetary and financial subsidies. A bailouts. Heavy losers with little future would need to be first priority would be to implement the new accounting closed down, while highly profitable enterprises could be system, set clear commercial objectives, streamline asset corporatized. management bureaus, clarify representation of the govern- * Systematically developing and implementing a program to ment on boards of directors, and transfer autonomous transfer the remaining 90,000 small industrial state enterprises management rights to enterprises. to the nonstate sector through sales! leases, or mergers. The gov- TiIE CIIINESE ECONOMY: FIGHTING INFLATION, DEEPENING REFORMS viii  ernment's proposed policy for such enterprises is to loosen activity will take their place (World Bank 1994). Important controls on leasing, mergers, sales, restructurings, and among these is control of monetary aggregates through bankruptcies. But the government should go further and open market operations. These considerations inform the systematically facilitate the transfer of these enterprises to following seven recommendations on financial sector the nonstate sector. A first phase could include the transfer reform in China: of 10,000-20,000 state enterprises in the eighteen reform * Reduce the scope and detail of the credit plan. State com- cities over two years. mercial banks already enjoy a little freedom in allocating fixed asset investment loans. By the end of 1997, it would Financial sector reforms be reasonable to expect that they would design their entire lending program on their own. The government could Problems in the financial sector mirror those of state enter- maintain some influence on credit allocation by placing prises. The parlous condition of public finances has placed ceilings (for example, not more than 10 percent of total a growing burden on banks to fund state-directed invest- loans to real estate) or floors (for example, not less than 20 ments and extend working capital loans to loss-making percent of all loans to agriculture). enterprises. The government's credit and investment plans * Reform interest rates in phases, reducing the most egregious steer the bulk of bank resources toward state enterprises at distortions quickly and subsequently extending greater freedom government-determined interest rates. The result is a bank- to financial markets to set interest rates. This is a complex and ing system with insufficient banking skills and a high pro- sensitive policy issue and needs to be approached prudent- portion of nonperforming assets; a central bank with limit- ly, but without delay. In the next two years, the government ed experience in monetary management, few policy instru- should immediately reduce the large number of officially ments, and inadequate regulatory and supervisory capacity; determined interest rates; let market forces increasingly and a volatile capital market. drive treasury bond pricing, initially by making purchases Previous attempts at liberalizing the financial sector voluntary and eventually by introducing treasury bill auc- accentuated macroeconomic instability because central tions; set interest rates quarterly, or more frequently if mar- bank controls were weak. They also shifted the pattern of ket conditions warrant; and expand bill rediscounting by investment in directions deemed undesirable by the gov- the central bank and open market operations. The govern- ernment. Learning from these experiences, the govern- ment could consider flexibility in lending (but not deposit) ment launched a gradual process of change across virtual- rates once it is satisfied with progress in commercializing ly the entire financial sector in November 1993. Important state banks. The central bank could alloxw all commercial features of these reforms include measures to strengthen banks to set interest rates freely on a small portion of their the central bank, the creation of three policy banks to portfolio, which could expand with time, or it could gradu- channel government-directed lending, and the transforma- ally widen the bands within which interest rates could fluc- tion of the four specialized banks into genuine commercial tuate. Once the net worth of banks was significantly posi- banks. tive, intermediation margins were acceptable and sustain- Building a stable, efficient, and safe financial system in able, and adequate loan loss provisions were available to C(hina will be a lengthy and complex process. In addition to protect banks from the possibility of nonrepayment of policy changes, it will require institutional and human loans, the central bank could introduce greater flexibility in resources development in areas as diverse as banking and deposit rates. accounting, government and public finance, and the judi- * Facilitate the transformattion of state commerczal banks into cial system. In addition, financial sector reforms will need genuine comnmercial banks. The government could consider to be synchronized carefully with reforms in other sectors increasing competition in the banking system, although of the economy, especially with state enterprise reforms. state commercial banks should be allowed to work out A primary objective of financial sector reform in China their inherited problems before they are exposed to full- is to phase out direct controls by government while relying blown competition. The banks, for their part, need to increasingly on commercial criteria. As these direct controls develop management information systems and introduce are withdrawn, indirect methods of influencing economic techniques for risk and asset-liability management, credit OVERVIELW ix  and risk evaluation, liquidity management, and risk-based Reform of public finance provisioning. * Shape the operations of policy banks to make them consis- Reforming public finances is as much part of establishing tent with financial sector and public finance objectives. Policy a market economy as reforming state enterprise and the banks should not be expected to bear the risks of lending financial sector. The government budget needs to accom- to projects not of their own choosing; nonrepayment of anv modate costs associated with market reforms, including such loans should be covered by the budget. In addition, budgetary contributions for a reformed social insurance the yield on policy bank bonds placed with state commer- system. At the same time, the budget needs to support cial banks should be aligned with bank lending rates to pro- development of critically needed social and physical infra- vide an accurate reflection of the actual cost of borrowing. structure to sustain a rapidly growing economy. The Ultimately, the placement of policy bank bonds should be steady decline of government expenditures over the last entirely voluntary, with the subsidy element in lending rates decade and a half has meant that some high priority gov- covered by the government budget. ernment activities have been underfunded. These include Improve the central bank's management of monetary aggre- the provision of health and education services, poverty gates. In the short term, the central bank could use such alleviation, infrastructure development, and environmen- existing instruments as reserve ratios, asset-liability ratios, tal protection. Our rough estimates indicate that funding and the rediscount facility to manage monetary aggregates these additional expenditure needs could amount to 4.6 more actively. Open market operations can then be increas- percent of GDP. That would bring budgetary and extra- ingly relied on to make short-term adjustments in liquidity. budgetary expenditure requirements to about 22.5 per- For open market operations to succeed, however, the cen- cent of GDP tral bank will need to permit greater flexibility in interest This level of expenditures will necessitate additional rev- rates in the money market and at the shorter end of the enues of about 6 percent of GDP, if the government's goal maturity spectrum. At the same time, central bank supervi- of a balanced budget is to be achieved. Raising that much sors will need to ensure that banks follow its prudential revenue will require a combination of continued economic guidelines in spirit and in practice. growth, a broader tax base, and improved compliance - Strengthen regulator oversight of nonbankfinancial institu- through better tax administration. The options available to tions. Laws on the operation and supervision of nonbank government are to: financial institutions need to be enacted to ensure that these * Improve the coverage and compliance of the value added tax. institutions conform to international norms of investor pro- By stepping up enforcement, the average compliance rate tection and information disclosure. To protect banks from could be raised from the present 70 percent to 85 percent by risks emanating from nonbank financial institutions, the the end of the decade. severance of ownership links between the two should be * Increase the application of the individual income tax. completed. Keeping the exemption constant in nominal terms (as was Increase the efficienc-, stability, and transparency of capital done in 1995) would bring an increasing number of people markets and lower 3ystemic risk. The steadv shrinking of the into the tax net, gradually increasing revenues. credit plan will permit gradual elimination of quotas for * Merge theforeign and domestic enterprise income tax rate. share and bond issues, while gradual interest rate liberal- This would not yield substantial revenues in the short term, ization will facilitate the issuance of government bonds but revenues would rise rapidly when the profits of foreign and deepen the bond market. To help develop the prima- enterprises rise. ry market, standards for credit rating agencies should be * Increase taxes on pollutants. Not only will such taxes set, competition among underwriters could be encour- encourage environmentally responsible behavior, they are aged, and the regulatory regime and oversight could be also easy to collect, and the sheer quantities of pollutants strengthened. In the secondary market, the bond markets makes such taxes attractive. of Shanghai, Shenzhen, and Wuhan could be linked, and - Introduce social securtyq taxes. Some form of social secu- daily price limits could be introduced to curb unusual rity tax will become necessary to finance the basic pension volatility. pillar for (urban) workers. TiIE CIIINI-SL LCONOMY: FlGHTING INFLA1'ION, DlPLIENING REFORNIS x  * Improve tax administration. A well-functioning tax direct controls over the economy need to be replaced by administration could significantly raise revenues from the indirect ones. An important example is the conduct of existing tax structure. monetary policy and the use of open market operations. Another is the reform of public finances. Government Conclusion attention needs to focus on allocating additional resources to such high priority areas as basic health and education, Maintaining rapid growth with stability will require contin- poverty reduction, infrastructure development, and envi- ued market reforms and a reorientation of government ronmental protection. Mobilizing revenues to meet these involvement in the economy. Benefits from further reforms additional expenditure needs will be central to China's would probably be greatest in state enterprises and the ability to sustain rapid growth with stability. financial sector. The government has made some progress in both areas; it is now critical to complete these reforms Reference with due attention to phasing and sequencing. World Bank. 1994. "Macroeconomic Stability in a Decentralized As important as market reform is the need for shaping a Elconomy," Report No. 13399-CHA, China and Mongolia new role for government in a changing economy. For one, Department. World Bank, Wlashington, D.C. OVERVIEW' xi  Summary of policy recommendations Objective Short term State enterprise reforms Improve governance, diversify ownership, anp lower subsicies Complete implementation of international accounting system. Increase autonomy to managers. Separate comMercial activities from ministries and bureaus. Lower subsidies through budget and banking system. * Among the government's priority l000 enterprises ncr 500 l -t: ;"r ' 'y' for utiities estblish dear regut ios ol tar *e Mtl-* * Among 4,000 mnedium anid large nrd-stVial state enterprses Separate out n-marginal state enterprises and distinguish inherently viable from effectively bankrupt ones Begin liqLiidatinig enterprises that have little chance of becoming viable. Cor poratize the most viable enterpr-ises. * Amrong 90,000 small industrial enterprises Tran$fer 1 020,000 small entrpriets tothe wsorW5taM* r 6S leases, or sales- T-ansfer social services to goverinment Tanisfer pension. health anid educatoni obligatons from enterprises to govern- ment nri at least the I 8 pilot cities with compnensatory fiscal transfers, if requiree. Introduce expermentation witn unemployment insurance system. improv e a ipton poicies fr all state-owvned eterprises. Reduce scope of admntirisled price s il . M n - . Phase Out resrbons on O' : , tra'det . ,',t Init:ate free entty .and et.;t ::emove taxt - s foring l fIrms and speco zoets - Contnue With rationaation of traand ir gme as with World trade Orpneiaio css ae-eet Financial sector reforms Reduce government s role in determin rig the allocation and cost of capital Reduice scope and detail of credit plan for commer-cial banks Simplify inter-est rate structure and adjust interest rates more frequently, increase inter-est rate spreads to reasonable levels, and introduce wider bands in the interbank market. Improve cent-at bank operations. Adveb( use iiredct irnstfents of m ey mlrprove institional framework for the central .bank. T-ansform state comnmercial banks into genuine -ommer-c al barks. Introduce sound management and accounting systems. Implemnent regulatory framewoork for commercial banks. Shpe operons of policy banks consistent with fincial sec apublic an y Into ea i Provide aldequat buday swpportto sustain bank bonds and subsidzied 11nding rates. TIII. (IIINI.sL I O()NO)NIY: I 1(,111T\( INHII AlIlN, I) LI' NIN(, RtELtORiMS xii  Medium term Long term Complete transfer of all fourteen autonomous rights to managers within the framework of the Company Law. Continue program. Introduce debt restructuring if fnancial s tuation and cor- Restructure r-ema ning margina but viable, state enterprises porate strategy ar-e acceptable to banks. Cont nue liquidation of nonviable state enterprises Complete liquidation of nonviable state enterprises Incorporate enterprises made viable after debt restructuring. Incorporate all medium and lar-ge state enterprises. bt vO~QQ ssUiaJ stat