China - The Chinese economy : fighting inflation, deepening reforms (Vol. 2 of 2) : Annexes

Report No. 1 5288-CHA The Chinese Economy: Fighting Inflation, Deepening Reforms (In Two Volumes) VolIme Il: Annexes April 4, 1996 Counrtrv Operations Division Chiina and Mongolia Department East Asia and Pacific Regional Office Document of the World Bank  ACRONYMS AND ABBREVIATIONS ABC - Agricultural Bank of China ADB - Asian Development Bank ADBC - Agriculture Development Bank of China BOD - Bank of China BOCOM - Bank of Communications CITIC - China Trust and Investment Corporation COE - Collective-Owned Enterprise CPIC - China Pacific Insurance Company CSRC - China Security Regulatory Commission CSY - China Statistical Yearbook DOD - Debt Outstanding and Disbursed DRS - Debt Reporting System FDI - Foreign Direct Investment FYP - Five Year Plan GDFI - Gross Domestic Fixed Investment GDP - Gross Domestic Product GNFS - Goods and Non-Factor Services GVIO - Gross Value of Investment Output IBRD - International Bank for Reconstruction and Development ICBC - Industrial and Commercial Bank of China IDA - International Development Association IMF - International Monetary Fund MLT - Medium and Long-Term MOF - Ministry of Finance NBFIs - Nonbank Financial Institutions NFS - Non-Factor Services NETS - National Electronic Trading System NTBs - Non-Tariff Barriers NTS - National Tax Service PBC - People's Bank of China PICC - People's Insurance Company of China PSD - Public Sector Deficit RMB - Renminbi SDB - State Development Bank SDR - Special Drawing Rights SETC - State Economic and Trade Commission SPC - State Planning Commission SOUs - State-Owned Units TFP - Total Factor Productivity TICs - Trust and Investment Corporations TVEs - Township and Village Enterprises  The Chinese Economy Fighting Inflation, Deepening Reforms Volume II: Annexes April 1996 World Bank  I  Contents Paee No. Annex 1: Financial sector and state owned enterprise strategy 1 matrices Annex 2: Public expenditure needs and options for revenue 10 mobilization Annex 3: Methodological note on the calculation of the public 25 sector deficit Annex 4: Technical note on the decomposition of China's 28 growth Statistical annex 33   Annex la Matrix of proposed financial sector reforms Overall obiective: Establish a financial system that efficiently mobilizes and allocates resources in a safe and sound manner to support rapid, stable, and sustainable growth. Subordinate objective Area Phase I Phase II Phase m (1-2 years) (3-5 years) (6-10 years) A. POLICY FRAMEWORK Reduce the role of 1. Credit Plan Reduce the share of the credit plan subject Restrict credit plan to policy banks Eliminate credit plan government in directing to project-by-project allocation only resources 2. Securities Market Eliminate provincial quotas for share and Eliminate aggregate quota bond issues; introduce aggregate quota 3. Interest Rate Policy State Council delegate decisions on interest rates to Monetary Policy Committee Simplify interest rate structure; increase Allow commercial banks the Liberalize interest rate completely. frequency of interest rate adjustments; freedom to set their own lending raise lending rates to real positive levels; rates for a small proportion of their increase spreads to reasonable level. asset portfolio; increasingly widen the bands within which lending rates can fluctuate. Sell increasing portions of treasury bonds Sell all bonds at market rates; all Sell all bonds at auction at market interest rates; initiate auctions rediscounting done at market rates. for small portions of bond issue; shift to rediscount facility by Central Bank 4. Tax Policy Review tax laws applying to financial Reduce tax rates on fmancial institutions institutions; make implementation of tax laws more rule-based  Objectlves Area Phase I Phase II Phase m (1-2 yean) (3-5 years) (6-10 years) B. CENTRAL BANK OPERATIONS Improve the Central 1. Legal Framework Promulgate and implement detailed rules Review implementation of Central Bank's management of and regulations related to new Central Bank Laws and revise where monetary aggregates Bank Law necessary 2. Control of Monetary Abolish direct lending by PBC for policy Restrict indirect funding of policy Remove policy loans from PBC's Aggregates purposes (except for agricultural loans though discounting; eliminate balance sheet procurement). PBC lending for agricultural procurement. Actively use reserve ratios, asset-liability Further expand use of indirect Use indirect policy instruments as ratios, and discount facility to manage instruments principal mechanisms for manaing monetary aggregates; expand open market monetary aggregates operations 3. Institutional Develop and extend payments system Complete China National *Development Automated Payments System Strengthen PBC supervisory capabilities; Reorganize PBC branches into develop strategy for reorganizing PBC regional central bank banches with branches clear supervisory responsibilities Vest PBC with authority to establish loan classification and provisioning methodologies C. STATE COMMERCIAL BANKS Tnmform state 1. Legal Framework Promulgate and implement detailed rules Review implementation of commercial banks into and regulations related to new Commercial Banking Law and genuine commercial Commercial Banking Law revise where necessary banks Bank's divest NBFIs  Objectives Area Phase I Phase II Phase m (1-2 years) (3-5 years) (6-10 years) Create legal and regulatory structures to enforce security interests and loan collection Review economies of scale and Based on review results, prepare Implement bank restructuring plans ownership structure of banks plans to restructure banks into smaller units and diversify bank ownership 3. Competition policy Establish clear licensing procedures for Initiate entry of foreign banks in Expand cntry of foreign banks in banks. Allow entry of nev domestic RMB business. RMNB business banks. 4. Institutional Implement new accotnting system and development upgrade management information system Conduct portfolio audits Assess bank capital adequacy Resolve bad debt problem and achieve intemational standards of capital adequacy w Introduce risk-based provisioning Ensure adequate provisioning for bad debts Introduce sound asset-liability management practices and risk management techniques in lending; introduce sound loan approval procedures and develop credit appraisal skills Conduct human resource needs audits Develop comprehensive training programs; introduce modem personnel management techniques  Objectives Area Phase I Phase II Phase m (1-2 years) (3-5 years) (6-10 years) D. POLICY BANKS Shape operations of 1. Policy and Institutional Issue detailed implementing regulations policy banks consistent Development related to charters of policy banks with financial sector and publicfinance objectives Limit the operations of the State Transfer "soft" window to the Development Bank to projects with high Ministry of Finance risk, long gestation, or low financial (but high social) profitability Set annual lending limits for policy banks consistent with development of commercial banking sector - SPC, SETC, and SDB to confer on SDB Increase SDB autonomy to identify lending program, with veto power for and finance part of public SDB investment program in line with its mandate Introduce incentives for loan collection in Introduce competition in selection agency relationship of agency relationship 2. Liability Management Extend explicit sovereign backing for all Consider tapping equity market for PB borrowing new capital if policy banks' performance merits; evaluate need for continued sovereign backing Set policy bank bond rates in relation to Review scope for policy bank bond commercial lending rates for loans of issuance directly to public; extend equal maturity; introduce voluntary maturity of bonds to reduce term placement of policy bank bonds; transformation risk  Objectives Area Phase I Phase l Phase mL1 (1-2 years) (3-5 years) (6-10 years) Maintain prohibition of policy bank deposit taking 3. Asset Management Policy banks to provision for bad debt and Policy banks to introduce and adequately account for interest in identify guarantees as part of suspense lending program Level of "soft" lending in SDB to vaiy in accordance with budgetary support SDB/SIDC to evaluate quality of assets acquired from former SICS; SIDC equity contributions to be given same degree of scrutiny as SDB loans. E. OTHER BANKS AND NBFI Separate NBFIsfrom the 1. Legal framework for all Prepare a law covering the operation and banking system and NBFIs supervision of NBFIs; complete strengthen regulatory severance of ownership links between oversight banks and NBFIs 2. Credit cooperatives Separate rural credit cooperatives from Provide a clear framework for rural ABC; prepare ground for transforming credit cooperatives under Central urban credit cooperatives into banks Bank supervision; start transforming urban credit cooperatives into banks 3. Trust & investment Restrict enterprise deposits in TICs Restrict govemment lending to TICs Restrict ownership of TICs by local corporations (TICs) governments 4. Leasing and finance Restrict banks from owning leasing and companies finance companies 5. Insurance companies Promulgate rules and regulations under new insurance law  Objectives Area Phase I Phase II Phase m (1-2 years) (3-5 years) (6-10 years) Establish oversight authority for insurance companies separate from PBC 6. Pension funds Establish oversight authority for pension funds separate from PBC 7. Mutual funds Transfer supervision to CSRC F. CAPITAL MARKETS Increase efficiency, Primary market: treasury Pre-aiuiounce aimual schedule ot Sell limited goverunenit debt stability, and bonds government debt issues; make savings directly to retail investors through transparency of capital bonds available throughout the year for savings bond marketsand lower retail investors systemic risk Primary market: equities Exchanges to enforce eligibility criteria Enforce better disclosure at time of prospectus issue 0 Expand auctions of initial public offerings Allow enterprises to set IPO dates (IPOs) Secondary market Shanghai, Shenzhen, and Wuhan Draw up standards for the Pcrmit dual/multiple listing in development exchanges to set standards for mutual recognition of regional trading exchanges other than Shanghai and recognition of bond certificates; start centers as exchanges; initiate dual Shenzhen study on dual listing in exchanges listing To reduce share price volatility, Introduce capital gains tax or share Consider opening "A" share market reintroduce daily price limits turnover tax to foreign investors Market infrastructure Leave selection of underwriters for share Encourage diversification of Permit foreign underwriters to issue to the market underwriting techniques compete in the domestic market Establish standards for credit rating Credit rating made precondition for Eliminate govermment approval for agencies IPO share issue  Objectives Area Phase I Phase H Phase HI (1-2 yean) (3-5 yean) (6-10 yeasn) Regulatory framework Pass the draft securities law, clarify Clarify legal regime for mutual overlapping jurisdictions of PBC and funds and other institutional CSRC investors Enlarge the CSRC and strengthen its Form CSRC regional offices supervision capacity  Annex lb Matrix of proposed policy recommendations for state enterprise reforms Objective Short tenn Medium term Long tenrm Improve govemance, diversify ownership, and Complete implementation of international accounting system lower subsidies and independent audits. Initiate transfer of 14 autonomous rights to managers. Complete transfer of all 14 autonomous rights to managers. Enact new state asset management law. Promulgate implementing regulations of state asset management law. Separate commercial activities from sector ministries and bureaus. Lower subsidies through budget and banking system. Refine property rights, governance regime, and corporatization for nonstate enterprises, for example by accelerating the establishment of cooperative shareholdmg companies among collectively owned companies. * among the Government's priority 1,000 Incorporate 500 large state enterprises under Company Law. Extend incorporation to remaining priority state co enterprises: enterprise Require public disclosure of independently audited annual repoets. For utilities, establish clear regulations for tariff setting * among 14,000 medium and large industrial Separate out marginal state enterprises and distinguish Continue program. Introduce debt restructwing after Restructure remaining state enterprises: inherently viable from effectively bankrupt ones. Ensure that financial situation and corporate strategy acceptable marginal, but viable, SOEs. new flow of working capital and investment loans from banks to banks. are for commnercially viable projects. Begin liquidating enterprises that have little chance of Continue liquidation of non-viable SOEs. Complete liquidation of non- becoming viable. viable SOEs. Corporatize the most viable enterprises. Require public Incorporate enterprises made viable after debt Incorporate all medium and disclosure of independently audited annual reports. restructuring. Require public disclosure of large state enterpnses. independently audited annual reports. * among 87,000 small industrial enterprises: Transfer 10-20,000 small enterprises to the non-state sector Extend program to 50,000 small SOEs. Transfer all remaining small through mergers, acquisitions, and sale. SOEs to non-state sector. Transfer social services to government Transfer pension, health, and education obligations from Unify municipal programs into national program for enterprises to Government in at least the 1 8 pilot cities, with pension and health, and implement in remaining compensatory fiscal transfers, if required. cities.  Objective Short tern Medium term Long termn Introduce experimentation with expanded unemployment Establish unemployment insurance program. insurance system. Improve competition policies for all SOEs Deregulate prices further. Eliminate administered prices for all but a few Eliminate all administered essential commodities. prices. Phase out restrictions on inter-provincial trade and Eliminate restrictions on inter-provincial trade and investment. investment. Initiate free entry and exit. Initiate entry of domestic and Expand free entry and exit. Eliminate all restrictions to foreign investinents into infrastructure (telecommunications, free entry and exit oil and gas, and power). Extend trading rights to all enterprises, subject to registration and other standards. Enact new bankruptcy law. Remove tax biases favoring foreign firms and special economic zones. Continue with rationalization of trade and investment regime Continue program. Complete program. as consistent with WTO accession agreemnents. '0  - 10 Annex 2 Reformine iublic finances for sustainable develoDment The decline in government revenues Education and health as a share of GDP, and an otherwise commendable desire to keep the budget China's record in human capital deficit in check, have led to a steady formation has been impressive and its social reduction in budgetary expenditures from indicators are high in comparison with low- 33.8 percent of GDP in 1978 to 14.1 percent income countries, and approaching those in in 1994. Extrabudgetary public expenditures higher middle-income countries. However, amounted to a further 3.8 percent of GDP. recent years show a declining trend in social sector spending. eroding China's The current level of China's favorable standing among comparator Asian budgetary expenditures is substantially countries. below that in industrialized and developing countries alike (Table A2.1). This appears Public expenditures on education to have yielded two sets of undesirable declined from 3.1 percent of GDP in 1985 to outcomes: (i) the emergence of a sizable 2.4 percent in 1994 (Table A2.2). This is in quasi-fiscal deficit, discussed in detail in the contrast to the Asian NICs, where steady last Country Economic Memorandum (World increases in public spending on education Bank, 1995); and (ii) underfunding of (especially basic education) played a priority activities, including in infrastructure, fundamental role in sustaining their high health and education services, and poverty growth. Part of China's declining share of alleviation, which perpetuate unacceptably education expenditures in GDP may be poor living conditions for a large segment of explained by demographics and China's one- the population and may threaten the child policy. Also, fees and self-raised funds sustainability of growth.' This annex have increasingly supplemented budgetary presents some estimates of the extent to resources, raising the financial burden on which government budgetary expenditures in poor households and reducing their access to key sectors fall short of needs, and puts schools. In addition, China is spending forward suggestions on how additional proportionately less on basic education than government revenues can be raised to finance East Asian comparators. In 1985, the share incremental expenditures. of basic education in China's total public education expenditures was 15 percent below Table A2.1: General government expenditures Central government Government expenditures as expenditures as percent of percent of GNP total expenditures All countries 39.1 72.3 Industrialized countries 47.6 65.9 Developing countries 31.7 77.8 China (budgetary, 1994) 14.1 40.2 Source: Ministry of Finance, Levin (1991), World Bank staff estimates. Levin's data are from a sample of 18 industrialized countries and 22 developing countries for which data on general government are available in the International Finance Statistics. Data are averages over three years ending 1987 or 1988.  - 11 - Table A2.2: Public expenditures on education (Percent of GNP) 1985 of which: 1989 basic education (percent) Hong Kong 2.8 69.3 2.8 Korea, Rep. of 3.0 83.9 3.6 Singapore 5.0 64.6 3.4 Malaysia 7.9 74.9 5.6 Thailand 3.2 81.3 3.2 Indonesia 2.3 China* 3.1 60.3 2.7 Memorandum item China (1994) Public: 2.4 Budget: 2.0** */ Public expenditures include budgetary expenditures, extrabudgetary expenditures from educational surcharge, and state enterprise expenditures on education.. Basic Education only applies to Governnent Expenditures, and is calculated u expenditures on primary education plus two thirds of secondary education. **/ 1994 budget number includes expenditure from the educational surcharge, which is not included in earlier budgetary nunbers. lhe surcharge amounted to about RMB 1Obn. or 0.4 percent of GDP in 1992. Source: Ministry Of Education; State Statistical Yearbook (1995); Asian Development Bank 1995; World Bank 1995a; World Bank 1993a. selected East Asian countries and this share Inequalities in education and health has been falling since. care--both in term of outcomes and expenditures -- remain large. Provinces with Overall spending in health has also lower per capita incomes and a higher been declining as a share of GDP (Table proportion of minorities tend to have weaker A2.3). While China's national health social indicators. (Table A2.4) For instance, indicators compare favorably to other functional illiteracy rates in the Far West are countries with similar per capita income twice those in the South Coast. The levels, these indicators hide substantial divergence in school attendance among the regional variation. Access to adequate health regions would predict a persistence in these care remains a problem for large segments of pattems. the population and affordability is a growing concem. Disparities in govemment spending contribute to this outcome. These disparities Table A2.3: Health Indicators, Selected Countries 1990 Health Public sector health Life Child expenditure expenditure expectancy mortality (percent of GNP) (percent of total) at birth (per 1,000) Established market economies 9.2 60 76 11 European former socialist economies 3.6 71 72 22 China (1990) 3.5 59 69 43) China (1993) 3.3 58? 69 54) India 6.0 22 58 127 Other Asia 4.5 39 62 97 Latin America 4.0 60 70 60 Note: Includes public insurance schemes Source: WDR 1993; Hussain (1995); ADB (1995); Social Indicators of Development  - 12 - Table A2.4: Regional education and health indicators, 1990 Income per Minority Functional 6-14 year Population: capita population illiteracy olds in natural rate of Infant (1992, US$) share rate xchool increase mortality (%) (%) (%) (per 1000) (%)_.. China (total) 470 8.1 22.3 81.6 1.4 34.5 East Coast 781 .3 21.7 84.9 1.1 19.5 SouthCoast 695 1.9 17.9 80.1 1.7 24.8 North Coast 608 4.8 19.2 86.6 1.1 16.0 North Hinterland 430 6.3 18.5 84.1 1.4 26.6 Far West 398 34.0 34.2 69.7 1.6 52.8 Central Core 332 2.8 23.9 82.5 1.7 36.4 South Hinterland 294 20.6 25.2 73.5 1.3 60.1 Source: World Bank 1995b. are large, and have grown with greater fiscal the highest eamers, the rural population is decentralization. The poorest regions with uninsured. Over the reform period, health the weakest fiscal base have the lowest per financing has shifted from the government capita expenditures, which are matched with budget and collective health schemes toward the highest private fees. However, many of insurance and user fees. Whereas the the poorer regions also have a large share of govemment budget financed 25 percent of minorities, which adds to education costs. health expenditures in 1980, it only financed Disparities among local budgetary health 13 percent in 1992 -- below levels in most spending show a similar pattern. Whereas Asian comparators (Table A2.5). Rural Anhui spends barely RMB 5 per capita per collective funding declined even more year, Shanghai spends RMB 39 and sharply, from 16.7 percent of health Guandong RMB 18. expenditures in 1990 to 5.5 in 1992, thus leaving most of the rural population paying Inequalities in access and care have user fees. These fees now finance over a been exacerbated by changes in the structure third of expenditures. of health care financing. The shift in health care finance towards insurance and insurance The govenmment can arrest a possible coverage has tended to concentrate the deterioration in China's social indicators, benefits of health care on the urban mitigate disparities in educational attainment population, especially government and health status, and promote growth by employees. Except for about 100 million of increasing the level of public expenditures Table A2.5: Financing of health expenditures (Percent of GNP) Government Insurance Private Total China (1992) 0.4 1.4 1.3 3.2 India 1.6 0.2 2.5 4.3 Indonesia 0.9 0.1 1.4 2.4 Korea 0.6 1.1 3.4 5.1 Malaysia 2.7 0.0 0.8 3.5 Thailand 1.1 0.0 2.6 3.8 Note: Countries other than China, data for 1986 or 1987. Source: Griffin 1992; Ministry of Health; World Bank 1995a; Asian Development Bank 1995.  - 13 - allocated to basic education and health. To Poverty alleviation achieve the goal of universal access to good quality basic education, government Despite considerable achievements in expenditures on basic education would have poverty reduction since the advent of rural to rise from the current 1.2 percent of GDP economic reforms in 1978, the number of to 2.1 percent of GDP by 2000. Of the 0.9 absolute poor in rural areas remains large percent rise in expenditures, about 0.5 and their living conditions deplorable. percent of GDP is necessary to bring the Recent years have also witnessed the expenditures per student in basic education emergence of an urban underclass as a to acceptable levels.2 The rest is necessary to consequence of increased internal migration. increase the enrollment ratio from the current The government has recognized the need for 81 percent to 100 percent. Assuming a special programs to target the rural poor constant share of GDP for government through the National Seven Year Plan for expenditures on higher education, this would Poverty Reduction (8-7 Plan). While the 8-7 put government education expenditures at Plan has had some success, eliminating about 2.9 percent of GDP. poverty in China will require increased public expenditures to meet the 8-7 Plan's The package of public health and own objectives, to reach the rural poor essential clinical services recommended in residing outside the targeted 592 countries the 1993 World Development Report (World and to address the growing problems of the Bank 1993) requires resources equivalent to urban poor. 3.5 percent of GDP for the whole population, close to current levels of spending on health The extension of the multi- care.3 A public health package alone -- pronged approach adopted in the Southwest arguably a government responsibility -- Poverty Reduction Project to all the poor in would require budgetary expenditures of 1.2 China would necessitate annual expenditures percent of GDP, almost three times current of about RMB 18 billion, or 0.33 percent of government spending on public health. GDP in 1995. 6 This is roughly double Adequate financing for basic clinical services current expenditures under the 8-7 Plan. for all Chinese is a larger task, as the While the Government's targeted programs resources needed for the uninsured amount to appear to have succeeded in reaching the 4 7 some 1.9 percent of GDP. However, the poor in the designated areas, some uninsured currently pay about 1.3 percent of refinements in approach (e.g. targeting below GDP in fees. It would, therefore, take an the county level) will be necessary to expand additional 0.6 percent of GDP in government coverage to others in rural areas and to spending to provide basic insurance develop a package to assist the urban poor. coverage. Environment Covering all basic clinical from the budget is probably not desirable for cost To combat environmental control purposes. A combination of degradation, there is a pressing need for: budgetary allocations for the poor, increased more effective regulatory control, in coverage of formal insurance schemes, and particular over TVEs; appropriate pricing to copayments for all--including government dampen demand and reduce pollution; and and SOE employees-- would serve such a allocating increased resources toward purpose better, and stands a good chance for meeting the investment and operating costs of providing adequate health care for all. municipal services, including sewerage, wastewater treatment, and solid waste  - 14 - handling. Spending on pollution control Estimates of investments increased from 0.4 percent of GDP in 1980 required to improve waste treatment and to 0.67 percent in 1992, but this remains water supply in cities where there are severe insufficient to deal with the nearly threefold shortages are in the order of RMB 100 billion increase in the output of heavy industry over a year over the next 10 years or 1.7 percent the same period. Total suspended of 1995 GDP. This compares with current particulate levels remain well above those urban water investments of only 0.35 considered safe by the World Health percent of GDP. Substantial budgetary Organization, sulfur dioxide concentrations funds are expected to be necessary for inter- exceed the lowest Chinese air quality basin transfer projects (15 to 30 percent of standard, few urban rivers reach the lowest project costs) and sewerage and industrial acceptable Chinese water quality standard, waste management (30 percent), yielding groundwater quality continues to fall at an budgetary requirements of some 0.3 percent alarming rate, and petroleum discharges to of GDP. surface waters are increasing after an initial decline. Only 4.5 percent of municipal Infrastructure wastewater flows receive treatment of any kind, while industrial pretreatment raises Infrastructure needs in China are overall treatment rates to 17 percent. The huge. This is not to deny that China has Government's goal for the year 2000 is a made tremendous strides in infrastructure modest 25 percent. Nearly 40 percent of investments in the last ten years. These urban China is unserved by sewers, with amounted to 7.5 percent of GDP in 1994, up wastewater going directly into lakes and from 4.4 percent in 1985. Higher tariffs (for rivers, and according to current municipal example, on power) and government-directed investment plans, 30 percent of urban China credit have been the principal sources of will still remain unserved in the year 2000. finance with only a small contribution from budgetary funds. This has resulted in The effects of untreated underfinding of infrastructure projects that wastewater on aquifer pollution and tend to be commercially non-viable but yield downstream supplies outside the producing large economic benefits.8 Of particular municipalities suggests that central concern is China's road infrastructure. government intervention is necessary to Physical indicators show that China fares safeguard water quality in China. A relatively poorly in comparisons with other wastewater treatment program for any large countries in per capita coverage of the discharge that reduces receiving water road network. It is, therefore, reasonable for quality to below irrigation use standards China to aim for 8-9 percent of GDP and to would cost about RMB 4.2 billion a year channel, in particular, increased budgetary over the next ten years, requiring an increase funds of some 0.5-1.0 percent of GDP to of 15 percent in the annual urban infrastructure investments with public goods infrastructure construction program. characteristics. Improved solid waste disposal (through landfills) might cost about RMB 5.2 billion a Contin2ent liabilities year. While the incremental cost of these interventions is a modest 0.3 percent of Public expenditure policies will GDP, cost recovery through increased user have to address not only underfunding of fees would result in a tripling of average priority sectors discussed above, but also effective water prices. manage the implications of increased market orientation for the budget. Tasks previously performed by other sectors of the economy  - 15 - Table A2.6: Budgetary impact of pension reform: simulating pension liabilities in 1994 RMEB billion percent of GDP Actual expenditures al 86.2 1.9 Proposed Scheme: b/ 78.8 1.7 First pillar 31.9 0.7 Second pillar 46.9 1.0 Resources already in budget for 29.6 0.6 pension payments Financing gap: 49.2 1.1 Budget 29.7 0.. Sale of assetstborrowing 19.5 0.4 a/ Pension expenditures of state-owned units b Benefit level reduced to 60 percent of wages. Source: World Bank staff estimates. will increasingly be shifted to the budget additional details but some rudimentary while in-kind benefits offered to civil calculations provide useful indications. servants will be monetized and contingent liabilites may increase. The implicit pension Pension expenditures now debt is estimated to equal around 50 percent account for some 2 percent of GDP and yield of GDP and according to official estimates,9 benefits which amount, on the average, to 70 about 20 percent of the state bank portfolio percent of wages. The bulk of these is nonperforming, which equals another 20 payments (excluding civil servants) are now percent of GDP. In addition, with economic assumed by enterprises. Under the proposed growth and rapidly rising wages, government scheme, the government would assume services are likely to become relatively more responsibility for the basic benefit, which we expensive, necessitating a larger government propose should equal 24 percent of wages, share of the economy.10 and for transition costs. Below, we demonstrate the impact of the new system on Pension reforms appear to be the budget using 1994 data (Table A2.6). gaining momentum. It is important to evaluate carefully the budgetary implications Pension expenditures of state- of various options. The government now owned units (that is government institutions appears to be favoring a multi-pillar and state enterprises) amounted to RMB 86.2 approach, the first of which would have billion in 1994. Of this, about RMB 29.6 welfare and redistributive objectives and be billion was financed through the budget. funded on a pay as you go basis. Fully- Under the proposed scheme, pension benefits funded mandatory individual retirement would be reduced to 60 percent of wages accounts would consitute the second pillar (compared to about 70 percent today). This and a voluntary scheme the third. A difficult would mean that total pension expenditures issue which remains to be resolved concems in state-owned units would amount to about the transition from the current unfunded to a RMB 78.8 billion. The first pillar would largely funded scheme in the future. A cost about RMB 31.9 billion; the second parallel study on pension reform will fumish would be about 46.9 billion. The calculations assume that the Government  - 16 - would have to bear the entire cost of the Budoetarv exDenditures revisited. second pillar until the individual accounts are fully funded. On the financing side, about Adjusting the level of budgetary RMB 29.6 billion was already available in spending to reflect the need for additional the 1994 budget. This would leave a expenditures in priority areas (as discussed financing gap of RMB 49.2 billion. We above), and the implicit and extrabudgetary propose that the Government finance this costs of all government activities yields partially through mandatory social security budgetary expenditures in 1994 of some 22.5 contributions deducted from wages percent of GDP (Table A2.7). This is equivalent to 6 percent of the wage bill. This substantially higher than current budgetary would amount to incremental resources expenditure levels and closer to international available through the budget of about RMB norms. 29.7 billion. The remaining RMB 19.5 billion would could be raised through asset Given the Government's decision sales of state enterprises that undergo to eliminate the budget deficit by the year restructuring or are sold to the non-state 2000, government revenues will have to sector (or declared bankrupt). reach 22.5 percent of GDP or double current levels of budgetary revenues (11.3 percent of Unemployment benefits will rise GDP). With extrabudgetary funds providing with increasing open unemployment in urban another 4.1 percent of GDP in fiscal areas. Assuming benefit levels which are resources, there is a need to generate equivalent to the public pillar of the pension additional resources equivalent to some 6 scheme and 5 percent urban unemployment, percent of GDP. A reversal of the declining budgetary outlays would equal 0.2 percent of trend in government revenues is therefore GDP. among the most important goals for the next five years. Table A2.7: Proposed expenditures: Cost of shouldering government responsibility Expenditures Percent of GDP Actual budgetary expenditures, 1994 14.1 Extrabudgetary expenditures a/ 3.8 Additional expenditures proposed 4.6 Education (0.9) Health (1.4) Poverty Alleviation (0.2) Environment (0.2) Infrastructure (1.0) Social Insurance (0.9) Adjusted budgetary expenditures, 1994 22.5 Financed bv: 22.5 Budgetary revenue 12.4 Extrabudgetary revenues 4.1 Additional revenues needed 6.0 a/ Based on 1993 figures Source: World Bank staff estimates; China Statistical Yearbook 1995  - 17 - Table A2.8: Composition of Government Tax Revenue (Percent of Total Tax Revenues) Personal Social Corporate VAT/genera Excise Trade Wealth income tax security tax income tax I sales taxes taxes and property Industrial 28 28 8 16 10 3 3 countries Developing 11 6 18 14 13 29 3 * Asia 15 0 17 16 16 31 1 * Europe 15 18 7 21 9 17 2 * Western 8 12 14 14 18 21 3 Hemisphere China(1994) 1.5 n.a. 14 46 11 6 Note: n.a.=not applicable; ..= not available.. For countries other than China, revenues refer to central government; for China to general government Source: R. Burgess and N. Stem, "Taxation and Development," Journal of Economic Literature, Vol XXXI (June 1993, pp. 762-830; and IMF. Mobilizing Revenues. comparable to other developing countries with similar tax bases, but falls short of the Increased revenues will have to top performers, which achieve 90-95 come from a combination of improved percent."1 Increasing compliance to 85 compliance, a broader tax base, and growth. percent, a feasible target in light of the In the short run, improvements in compliance ongoing tax administration reforms, would are likely to contribute most to increased yield about 1.0 percent of GDP in extra revenues. In addition, the phasing out of the revenues. Each additional percent in plethora of tax exemptions for both domestic compliance would yield about 0.067 percent and foreign firms would improve buoyancy of GDP in revenues. Extending the VAT to of the tax system. In the longer run, services, which is desirable for efficiency however, tax reforms may be needed to reasons, would increase the VAT tax base by further increase the tax to GDP ratio. about 8.6 percent of GDP12 but would not necessarily generate additional revenues as China's current tax structure the sector is now subject to the separate relies predominantly on taxes on goods and business tax. services, notably the VAT. The tax base in other countries is much more diversified than In the longer run, China's China's (Table A2. 8 ). Notably, the authorities could consider changes to the personal income tax, the enterprise income VAT that would reduce revenues. The tax and social security taxes play a much current inability to credit the VAT on larger role. investment goods introduces a bias against investment and is out of line with Improve the coverage and international practice. Moreover, if credits compliance of the VAT The VAT raised on investment goods were permitted, the about 4.9 percent of GDP in revenues in VAT base would be reduced by a third.13 1994, almost half of total tax revenues in This is inadvisable at this stage not only that year. However, the potential revenues because the potential revenue loss cannot be from VAT are considerably larger. At about absorbed now, but also because the tax 70 percent, compliance in China is system counteracts powerful biases in favor  - 18 - of investment in the rest of the economy. the tax net. However, with wages The VAT on investment goods could be increasingly narket determined, and a credited, however, once increased coverage monetization of subsidies that wage earners and compliance have raised revenues, and now obtain in the form of housing, education, financial sector reforms have provided a and health care, it is likely that a larger share better check on investment demand of value added will accrue to labor. By keeping the exemption level constant in Increase application of the nominal terms (as was done in 1995), an Individual Income Tax. The individual increasing number of people would fall under income tax plays a small role in China, with the tax, and revenues could gradually less than 0.2 percent of GDP in revenues in increase. Simulations on the basis of the 1994. As with the VAT, this is in part due urban household surveys indicate that -- with to low compliance. Although information on current exemption levels and tax rates, and all taxes due is scarce, the State Tax with an annual 15 percent nominal growth in Administration estimates a compliance rate incomes -- revenues from individual income of 50 percent in 1994. taxes would rise from virtually nothing in 1994 to 0.4 percent of GDP by the year 2000 The current exemption level of (Table A2.9). 14 However, the authorities RMB 800 per month for wages and salaries would have to process 160 million taxpayers, is much higher than the minimum living compared to the current 30 million (Table expenditures usually exempted in other A2. 10). countries, and keeps most individuals outside Table A2.9: Personal Income Taxes Due According to the Urban Household Survey Income Deciles HI+IV V+VI VII+VmI IX X Proportion of total households 20.00 20.00 20.00 10.00 10.00 Total number of employees 39.53 39.95 40.78 20.08 19.24 (mml.) Income per employee 4871 5649 6608 7861 104623 Tax per month per employee 3.6 Total tax each year (in RMB 829.2 million) After 15 percent nominal growth over 5 years Incomeperemployee 9797 11363 13291 15812 21042 Tax per month 0.8 7.4 15.4 25.9 70.4 Total annual tax (in RMB 389.8 3521.0 7527.3 6236.1 16244.6 million) Tax as percent of GDP 0.00 0.03 0.07 0.06 0.15 Note: Income per employee was found by multiplying income per capita by the number of household members, and divided by the number of employees in the households. The aggregate number of employees was found by extrapolating the sample results to the aggregate urban population. It was assumed that the Y800 exemption level for wage income applied to all employees. The simulated results are found by applying the 15 percent annual growth to the income per employee, while holding the total number of employees, the income distribution, and the tax exemption level constant. All Survey Data are Urban. All rural Incomes would, according to the published surveys, still fall below the Y800 exemption, even after the assumed growth. Source: China Statistical Yearbook 1995, p.261, and World Bank staff estimates.  - 19 - Table A2.10: Individual Income Tax in the Year 2000 Under a Flat Tax Rate Individual income Tax Taxpayers (percent of GDP) (in millions) Flat tax rate of 25 percent 1.59 160 --with RMB 1,200 exemption 0.43 40 --with RMB 1,000 exemption 0.84 60 Flat tax rate of 30 percent 1.90 160 --with RMB 1,200 exemption 0.52 40 --with RMB 1,000 exemption 1.01 60 Source: China Statistical Yearbook, 1995, and Staff Estimates. In due course, China may taxed in the home country of the investor, consider revising the individual income tax and thus hardly affects the decision to invest rate schedule. Revisions would reflect in China. Finally, tax advantages for foreign decisions on whether the individual income enterprises increasingly induces "round tax is to be an instrument of equity or an tripping" by domestic enterprises. A important source of revenues. If equity is the unification of domestic and foreign taxes has primary goal, then the tax should target therefore become desirable. principally the highest 5-10 percent of income earners. If, on the other hand, Unification would not yield revenues are an important motivation for the substantial additional revenues in the short income tax, a broad based tax, applicable to term because the tax base of foreign a large number of taxpayers should be enterprises is small.15 The current low conceived. The latter option would place a profits of the foreign enterprises can in part greater burden on the tax administration. In be explained by the long gestation period of both cases, however, the current highly investments made. Assuming a gestation schedular income definition could be period of four years, the profit-generating replaced by one that encompasses most stock of foreign investment could be as high income sources. In the latter case, a flat tax as US$152 billion, or about 17 percent of rate would be preferable from an GDP, by the end of the century. Pre-tax administrative point of view, because this profits would need to be about 3.8 percent of allows the vast majority of tax obligations to GDP to generate after tax retums of 15 be fulfilled by withholding at the source, percent for investors, a rate which is low by without the need for filing a tax retum. intemational comparison. Thus, a 33 percent tax rate could add 1.2 percent of GDP to tax Merge the foreign and domestic revenues. enterprise income tax. Foreign funded enterprises are still subject to lower Increase taxes on pollutants. enterprise taxation than domestic ones, and As environmental concems become more enjoy a number of tax and tariff exemptions. prominent, but are unlikely to be fully taken Favorable treatment may have been justified care of by environmental levies and charges, in the past as means of attracting foreign taxing pollutants becomes an attractive enterprises that transferred technology to option. Moreover, the concentrated China. However, increasingly, foreigners production and distribution of the main invest in China because of the attractive pollutants (coal, petroleum) makes such market the country offers. Moreover, much products easy to tax. Finally, the sheer of China's subsidy to foreign enterprises is quantities of pollutants used in China makes  * 20 - taxing them an attractive proposition. To security taxes, as these taxes tend to have illustrate, China produced 209 million tons of large numbers of taxpayers. The 1994 oil products in 1994, including crude oil. decision to split the tax administration into a Taxing all oil products at I RMB per liter national tax service (NTS)--which is to would generate about RMB 133 billion, or collect the bulk of the taxes-- and a local tax almost 3 percent of GDP in revenues.16 If service (LTS) could mean a break with the only non-industrial use is taxed, such a tax problematic past of China's tax may still yield almost RMB 50 billion in administration, when the "dual leadership" additional revenues, or 1.1 percent of GDP. undemuined implementation of the tax laws. The authorities need to seriously consider Essential for the success of the NTS is: this important and easily-collected tax. The revenues from taxes on pollutants need not * a move toward taxpayer self-assessment be earmarked for environmental purposes. and withholding, which would allow Environmental projects in China can be significant increases in the number of financed from general budgetary resources, taxpayers, necessary to accommodate the through the normal budgetary process. administration of individual income taxes, payroll taxes, and the enforcement Mandate social security of enterprise income taxes for nonstate contributions. These contributions could enterprises; finance govemment's plans to introduce a * a reform in internal organization of the minimum pension for all (urban) workers. A tax administration, which focuses on pay-as-you-go basic pension provision does administrative functions rather than not necessitate a separate tax, but experience types of taxes or types of enterprises; of other countries shows that payroll taxes * development of efficient audit selection for a generally accepted purpose such as and audit procedures, which limits audit social security yield less resistance than other to those most likely to default on their taxes. Moreover, enforcement becomes tax obligation; easier when eligibility is linked to paid-in * development of best-practice premiums, as the payee has an interest in computerized information systems with regular payments. Most countries levy social main processing at county or district security contributions as payroll taxes, and level; therefore the administrative requirements are * a change in the incentive system for tax much the same as those for a widely applied administrators to enhance tax personal income tax. As discussed above, a enforcement and fight corruption; payroll tax of 6 percent (0.9 percent of GDP) * close cooperation between the NTS and could cover public pension liabilities and the LTS. At a minimum, information provide for unemployment insurance. sharing is necessary to improve enforcement of VAT and IIT. Over Improve tax administration. A time, the LTS may increasingly want to prerequisite for increasing the revenue to shed some of its responsibilities to the GDP ratio is a well functioning tax NTS, once the latter has become an administration. Improving tax administration efficient and neutral tax collection is also a precondition for more widespread agency. application of personal income tax and social  - 2 1 - * improvements in the juridical leadership" of the NTS should be firmly environment. In most countries, the tax embedded in its organization, mainly through administration can inplement a system central benefit and personnel policy, but also of stiff, but fair, monetary fines for by unifying administrative procedures and various tax offenses, without the information systems across all local offices assistance of the judiciary. Such of the NTS. arrangements greatly increase compliance while not overburdening the Attention will also need to be judiciary with small tax cases. given to raising non-tax revenues. Further * improvements in methods of price reforms in government services, presumptive taxation. Since the tax including housing, provide significant scope administration will only over time be for revenue mobilization, and would able to handle increasing numbers of contribute to the efficient use and production taxpayers, improvements in the methods of these services. Moreover, further price of presumptive taxation could be a good reforms in public services would reduce the short-term measure for enhancing policy losses that burden the budget at revenues, and bringing tax payments present. Finally, revenues from divestiture more in line with statutory obligations. may increasingly play a role as ownership of state assets becomes more diversified. The ongoing tax administration reforms envisage many of the above features. Increased enforcement, tax base However, the central government may face broadening, and some tax policy steps could significant opposition the local governments therefore increase the tax to GDP ratio by as in establishing a truly national tax much as 5.7 percent over the next five years administration, since this limits the discretion (Table A2.1 1). The current of local governments to grant tax intergovernmental fiscal arrangements would exemptions. Failure to establish a truly yield central government revenue increases of national organization may jeopardize the 2.6 percent of GDP. necessary revenue increases. Thus, "vertical Table A2.11: Sources of incremental revenues Revenue effect by 2000 of which: Central Measure (percent of GDP) Govermnent revenue a/ Value added tax 1.1 0.6 Individual income taz 0.8 0.0 * Improve compliance (0.2) 0.0 * Broaden base and expand definition of income (0.6) 0.0 Enterprise income tax 1.2 0.6 Social security contributions 0.9 0.6 Taxes on pollutants 1.0 0.6 Improve tax administration 1.0 0.4 Total 6.0 2.8 a/ According to latest arrangements for sharing tax revenues between the center and the provinces, the VAT on imports is a central revenue; the rest is shared 75:25 (center-local) but central government returns 30 percent of the increase over the 1993 revenue to the locality. Thus the effective sharing is 52.5:47.5. It is assumed that half the foreign investors pay income tax to central government and that social security contributions would be split evenly. The distribution of the tax on pollutants depends on whether such a tax would be treated as a consumption tax (central) or as a resource tax (shared). Source: World Bank staff estimates.  2 22 - While an increase in government increase by more than 3 percentage points of revenues equivalent to 5.7 percent of GDP GDP by the end of the 9th FYP. seems large, the distributional consequences remain limited due to China's high growth. The intergovernmental grants For the other sectors of the economy, it scheme should both redress differences implies that available income would still rise between provincial expenditure assignment at an average annual rate of 6.9 percent.17 and revenue raising capacity, and distribute Therefore, the revenue increase is not only fiscal capacity more equally among economically, but also politically feasible. provinces. Diverging economic development has created large differences in fiscal Intereovernmental Fiscal Relations capacity among provinces, and increasingly within provinces. The resulting disparities in The quality and effectiveness of government expenditures may perpetuate government policy depends to a considerable income differentials, since public goods extent on the division of labor among levels financed by government are an essential of government and the means by which these ingredient for development. Increasing levels of government are funded. China's income disparities induce migration from the size and its composition of government poor to the rich areas, aggravating expenditures restrict the role of central environmental and urban poverty problems in government in policy implementation, and the latter. Furthermore, increasing regional only about 40 percent of expenditures are disparities may undermine the political basis currently administered by central for the reform measures necessary to government. However, the new revenue maintain China's high growth. Thus, both assignments introduced in 1994 will increase rich and poor provinces have an interest in central government's share in revenues to a well-designed, equalizing grants about 60 percent. Government's main mechanism. challenge in intergovernmental fiscal relations is therefore to design and implement Currently, Government is a grants scheme that will redistribute central studying the feasibility of a grants government's revenue surplus to the mechanism that would take both revenue provinces. capacity and expenditure needs into account, along the lines of the Australian standard The overarching objective for budget approach. In the short run, due to the intergovernmental grants scheme is problems in budgetary and other data, a good redistribution. The growing fiscal strategy would be to start with a scheme that disparities--in overall revenues and in terms takes only a limited number of factors into of expenditures in key categories--threaten an account, and redistributes only part of central equitable division of the gains from reforms, government's revenue surplus. Over time, as and thereby weaken the consensus on these the budget mechanism is improved, and the reforms. Although supporting measures in grants scheme is fully operational, more regional policy --such as regional targeting of factors can be taken into account, and more foreign investment--may contribute to a resources can be devoted to the scheme. better distribution of government resources, the burden will fall initially on the A good central-provincial grant redistributive nature of central-local grants. scheme may not be enough to guarantee each The scope for such a grants system can be Chinese with essential government services. considerable, if the discussed measures in Many of the disparities in fiscal capacity are revenue mobilization are actually among prefectures and countries within the implemented: central revenues could same province. To redress those, central  - 23 - government could supplement the central- World Bank 1995a. "China: Social Sector provincial grants scheme with a prefectural Expenditures", mimeo., China and Mongolia one (comparable to the German Department, World Bank. finanzausgleich). However, such a system is World Bank, 1995b. China: Regional unlikely to be developed in the near future, Disparities. Report No: 14496-CHA due to its complexity, and the dearth of good (Washington, DC: World Bank) information at subprovincial level. World Bank 1995c. China: Public Investment and Finance, Report No. 14540- As an alternative, government CHA, (Washington D.C.: World Bank) could earmark increased resources for poor World Bank 1993a. The East Asian Miracle countries, relying only on income per capita (New York: Oxford University Press) data. The current program is small, and World Bank 1993b. World Development limited in scope, but increased central Report, 1993: Investing in Health (New resources would give an opportunity to York: Oxford University Press) expand the program, and reach all of the 70- Brondolo, J. and C. Silvani 1993. "An 90 million poor with adequate government Analysis of VAT Compliance", mimeo., services. Such a program could either be in IMF, 1993. the form of a general grants scheme, or the central funds could be specifically earmarked Endnotes for essential govemment functions such as health and education. Care should be taken The poorest 5 percent of rural China's to guarantee additionality of such 2200 counties saw near-zero growth in average government funding, because a change in income over 1985-91 (Howes and Hussain subprovincial intergovernmental fiscal 2 We chose Liaong Province as arrangements might otherwise counter the representative of an "acceptable" expenditure effect of additional central government funds. level. Liaoning Province is the non-city province with the highest expenditures after References Tibet. For primary education, additional expenditures of about RMB 9.9 billion would be Asian Development Bank 1995. Financing necessary in 1993, or 45 percent of all budgetary local government in the People 's republic of expenditures on primary education. A 45 China (Manila: Asian Development Bank). percent increase was also applied for secondary Burgess R. and N. Stem 1993. "Taxation education expenditures, for which data are not available. and Development", Journal of Economic 3 World Bank 1993b, p. 68. The World Literature, Vol XXXI June 1993, pp. 762- Development Report estimates per capita costs 830 of public health and basic clinical services in Griffin, C. C. 1992. Health Care in Asia: A China at US$4 and US$8, respectively, in 1990. Comparative Study of Cost and Financing 4 The basic clinincal package would cost (Washington D.C.: World Bank) 2.4 percent of GDP. However, about 220 million Howes and A. Hussain 1994. "Regional were uninsured. The numbers are based on the Growth and Inequality in Rural China.," 1993 health services survey, as reported in Working Paper EF 1, STICERD, London World Bank 1995a. The survey included both School of Economics. urban and rural data. SchootsnaJalanf EcondoMartinc Ravallions1 5 This is less than could be saved by Jyotsna Jalan and Martin Ravallion 1995. reducing spending on Govermnent and state "Are there dynamic gains from a poor-area enterprise employees from over three times the development program?" mimeo., Policy national average to two times the average. One Research Department, World Bank, means to do this would be by introducing co- November 1995. payments for Government and SOE employees.  - 24 - 6 The Southwest Poverty Reduction assuming these enterprises pay no tax at this project targets some 3 million poor in 40 time. counties and costs about US$ 400 million over a 16 A tax of RMB 1 would gross RMB 209 5-year period. The calculations here assume billion. However, the price increase would RMB 200 capita of expenditures in poor reduce profits, taxed at 33 percent, thus counties, excluding the health and education implying foregone income tax of RMB 68 package which are costed separately; the billion. Moreover, diesel and gasoline are equivalent urban package is assumed to cost 40 currently already taxed at 0.1 and 0.2 RMB/liter, percent more. which would lower the gain by another RMB 4.5 7 See Jalan and Ravallion 1995. billion. All numbers refer to 1994 (China 8 In 1992, budgetary financed 7.4 Statistical Yearbook 1995, p.205). percent of infrastructure investments, a share 17 The current non-government share is marginally higher than the contribution of the 87.5 percent of GDP. If we assume 1995 GDP budget to all state investment (World Bank, to be 100, a growth rate of 8.5 percent a year 1995c). would mean a GDP of 150 by 2000. Of that, 9 Statement by Mr. Dai Xianlong, government would take 18.6 percent (excluding Governor of the People's Bank of China, quoted extrabudgetary funds). Thus, nongoverrment in the Financial Times, October 24, 1995. income would grow from 87.5 to 122 which 10 The main cause of this so-called implies an annual growth rate of 6.9 percent. Baumol effect is lagging productivity in nontradables such as government services. If government wages keep up with non- government wages, the relative costs of government increases. The new civil service system provides for wage increases in line with wages in state enterprises. I I The estimate for China's compliance rate was provided by the State Administration for Taxation, and is based on the 1992 input- output tables. Compliance numbers for other countries are taken from Brondolo and Silvani 1993. 12 Consumption of services added up to 19.2 percent of GDP in 1990. However, the net addition to the VAT tax base would be less, since industry had about 10.6 percent of GDP of inputs to the services sector. 1 3 This assumes that the share of non- construction investment in 1994 was the same as that in 1990. Non-construction investment would then be about 29 percent of GDP. 14 The simulations are illustrative. The household surveys, as published in the China Statistical Yearbook, provide insufficient detail for adequate projections of revenues from the individual income tax. 5 For industrial enterprises--the vast majority of foreign invested enterprises--after- tax profits amounted to only RMB 19.7 billion in 1994. Maximum revenue gains would therefore be about 0.15 percent of GDP,  - 25 Annex 3 Note on the Calculation of the Public Sector Deficit Table 1.4 in the main report shows the deficit. There is even less infornation available evolution of the non-financial public sector on stock and bonds issued by enterprises. It is deficit or public sector borrowing requirements assumed here that all enterprise bonds and stocks between 1987 and 1995. The concept was are issued by state enterprises and that they are utilized to gauge more broadly the resource held either by households or the non-state sector. requirements of the Chinese public sector, defined to include all state-owned units, or state- Foreign financing. This category includes owned enterprises as well as government foreign lending and equity investments in state agencies and institutions. The calculations break owned units. It is assumed that all public and down the aggregate public sector into its publicly guaranteed medium and long-term debt government and state enterprise components and finances the state sector (source: World Bank generate the savings of each unit, given their Debtor Reporting System) and the table includes respective expenditures on investments. net medium and long term borrowing converted into local currency at the official rate. Short- In the absence of reliable enterprise accounts term flows are excluded. It is assumed that to determine the non-financial public sector foreign direct investment goes to the nonstate deficit, the calculations aim to capture the use of sector but there are some definitional problems all resources by state owned units that are not regarding the classification of joint ventures. self-generated. The borrowing requirements are Investment data report foreign funded enterprise thus calculated from the bottom up, using investments as a separate category only since financial data. We aggregate all lending to, or 1993; prior to that year, they are included in investment in, state owned units by the domestic investments by state owned units, resulting in an banking system, the non-state sector and overstatement of public sector savings. households, and by foreigners. While the approach is straightforward, there are some Borrowing from the domestic banking problems due to insufficient disaggregation and system. This is the largest category of deficit incomplete data. The discussion below provides financing, yet the calculations are subject to the details of the computations and various greatest uncertainty. In line with the assumptions. methodology we have adopted, this category needs to reflect net public sector borrowing from Borrowing from the public and non state the banking system -- that is, net credit to the sector. This category includes securities (bonds public sector minus any increase in deposits. We and stocks) issued by state owned units and held take net credit to the government from the by households or non-state enterprises. While monetary survey but calculating this for data are available on the shares of treasury-bonds enterprises is problematic in the absence of a issued to households, financial institutions and breakdown of lending and deposits by ownership enterprises (source: Ministry of Finance), it is not category. For the purposes of these calculations, possible to break down enterprise bond holdings we assume that Chinese banks specialize in into the state and non-state sectors. The clientele, with the state commercial banks and calculation assumes, therefore, that all treasury- universal banks (together called "national bonds issued to enterprises are held by state commercial banks") handling state enterprise enterprises, implying intra-public sector accounts while rural and urban cooperatives transactions which do not affect the aggregate cater to the nonstate sector. Specifically, we  - 26 - assume that: 70 percent of all deposits in the calculations are vulnerable to inadequacies in the national commercial banks are held by SOEs; all monetary survey. This survey shows large working capital loans made by the national increases in the "other items, net" category commercial banks to industrial, commercial and during certain periods, reflecting in part diversion construction enterprises are made to state of funds towards activities outside the credit enterprises; and all fixed investment loans made plan, largely through the interbank market. To by the State Development Bank and the national the extent that these funds finance state owned commercial banks are made to state enterprises. units with nonstate resources, the calculation in 'the table understate the non-financial public In addition to the difficulties associated with sector deficit. classifying loans and deposits by ownership, the  - 27 - CHINA: Non-financial Public Sector Deficit (billion yuan) 1987 1988 1989 1990 1991 1992 1993 1994 1995 Borrowing from the public and nonstate sector 5 13 21 6 26 68 26 87 87 T-bonds issued to households 4 8 17 1 9 17 22 87 87 T-bonds issues to nonstate enterprises State enterprise bonds issued to households and 0 3 3 5 14 40 0 nonstate sector State enterprise equity issued to households and 1 3 1 0 3 11 4 nonstate sector Foreign borrowing, net 1/ 23 25 23 30 24 62 74 103 81 Borrowing from domestic banking system 100 121 150 191 187 219 337 257 317 State owned enterprises 85 111 156 174 171 131 369 165 237 change in deposits 2/ -31 -17 -10 -64 -74 -134 -50 -266 -214 net credit, working capital 3/ 93 102 148 197 169 182 295 230 166 net credit, investment 4/ 23 27 18 41 76 83 125 200 286 Government, net credit from PBC 5/ 15 10 -6 17 16 43 7 -23 -24 State Development Bank 76 80 Total public sector borrowing 128 160 193 228 237 350 437 447 486 Total non-financial public sector deficit 10.7 10.7 11.4 12.3 10.9 13.1 12.7 9.9 8.7 (as percent of GDP) of which: State enterpnses 8.6 8.4 9.2 10.3 8.7 10.8 10.6 8.2 7.0 Government 2.1 2.2 2.2 2.0 2.2 2.3 2.0 1.7 1.7 Financing the deficit (as percent of GDP) 10.7 10.7 11.4 12.3 10.9 13.1 12.7 9.9 8.7 Foreign borrowing 1.9 1.7 1.4 1.6 1.1 2.3 2.1 2.3 1.5 Domestic borrowing 8.8 9.0 10.0 10.7 9.8 10.8 10.6 7.6 7.3 Public 0.4 0.9 1.2 0.3 1.2 2.5 0.7 1.9 1.6 Banking system 8.4 8.1 8.9 10.3 8.6 8.2 9.8 5.7 5.7 From PBC 1.6 3.9 1.8 1.2 0.2 4.6 3.4 -2.7 -3.4 From other banks 6.8 4.2 7.0 9.2 8.4 3.7 6.3 8.4 9.1 1/ Disbursements of public and publicly guaranteed loans converted to local currency at the official exchange rate. Foreign direct investment is not included on the assumption that this goes to the nonstate sector. But note that state sector investment data prior to 1993 include investments by foreign invested enterprises. 2/ From change in "enterprise" deposits in specialized and universal banks; assumes 70% of these are state enterprise deposits. 3/ Includes loanls to industrial, commercial and construction enterprises by specialized and universal banks. 4/ Fixed investment loans by national banks and the State Development Bank. There is a large discrepancy between loans recorded in investment data and investment loans recorded by banks. There are several explanations: 1) bank data only report investment loans by national banks, and do not include urban and rural credit cooperatives (although bank data on investment loans are also substantially lower than data on state sector investments financed by bank loans; 2) investment data report gross lending, bank data show net credit; and 3) investment data include enterprise bond issues. 5/ From the monetary survey  - 28 - Annex 4 Technical note on the decomposition of China's arowth This annex details the growth Lij=employment in sector ij accounting framework used in the introduction to Part II of the report. It Differentiation of this expression explains the methodology we used to yields the following decomposition of the determine the contributions of aggregate growth rate of GDP: factor accumulation and the improvements in the efficiency of the allocation of labor gy = i9 gK + (1 - J) g L + E lij RYij gk across sectors to growth in China between (2) 1985 and 1994. l The two main sectoral JYj (2) shifts of interest are: (1) the transfer of labor ij Y Y out of agriculture into the industrial and service sectors, and (2) the transfer of non- agricultural labor out of the state sector and where into the collective and non-state, non- collective sectors.2 Of an average annual g,= growth rate i variable x growth rate of 10.2% between 1985 and l y D = the share-weighted average 1994, 6.6% is due to factor accumulation. ij Of the remaining 3.6%, 1.2% is due to capital share in the economy efficiency gains resulting from the yj = value share of sector ij in value added, intersectoral reallocation of labor. The p1jYijY remaining 2.4% consists of productivity kjK= share of sector ij in total capital K, growth and efficiency gains from improvements in the allocation of capital l1j= share of sector ij in total labor L, L1j/L across sectors. The first two terms in Equation (2) Methodolo2v can be interpreted as the contributions of aggregate factor accumulation to growth. The sectoral breakdown of value 'he remaining three terms can be interpreted added by form of ownership may be written as aggregate efficiency growth, as they as: correspond to the portion of aggregate GDP growth which cannot be explained by growth Y =pij' ii=Pi A,q'Kg" L'''.'' (1) in inputs. Of these three terns, the first 2.ij ' iju = ' ' '' measures the effects of the reallocation of capital between sectors, holding constant the where total capital stock. The second measures the same reallocative effect for labor, while the Y=GDP final term is a weighted average of sectoral i=Agriculture (A), Industry (I) and Services TFP growth rates, and corresponds to true (S) aggregate productivity growth. j=State-Owned (S), Collectively-Owned (C) and Other Ownership (O) ~~Using agniculture as the reference and Other Ownership (0) Yij=Value added in sector ij sector, it is possible to clarify the role of the plj =relative price of value added of sector ij intersectoral reallocation of labor to growth Aij=level of total factor productivity (TFP) in by rewriting the labor reallocation effect as: sector ij Kij=capital stock in sector ij  - 29 - LRE== L L/Y{MPLij -MPL,JgI lij (3) its sectoral decomposition into agriculture, i=1Sj=S,C,O industry and services are based on official statistics (CSY 2-1).6,7 Labor input is where measured as total employment. The distribution of aggregate employment MPLA= value of the marginal product of between agriculture, industry and services is labor in agriculture3 based on official statistics (CSY 4-3), but is MPLij= value of marginal product of labor in adjusted to account for the large "floating sector ij population" of rural-urban migrants.' The aggregate capital stock is drawn from Nehru This expression shows that a and Dhareshawar (1993), and is updated reallocation of labor towards sector ij (i.e. through 1994 using official investment an increase in the share of labor in sector ij, statistics. glij>O) will contribute positively to the labor reallocation effect as long as the value of the The distribution of non-agricultural marginal product of labor in sector ij exceeds employment by ownership can also be that in agriculture, and the size of this effect constructed from official statistics. Non- depends on how much more productive the agricultural employment consists of staff receiving sector is, and how large the share and workers9, rural COE employment of labor in the receiving sector is. (consisting primarily of township and village enterprises (TVEs)) and urban and rural The above expression combines two employment in privately and individually- distinct reallocation effects: the reallocation owned enterprises. The distribution of staff of labor out of agriculture, and the and workers by sector and by form of reallocation of labor from the state to the ownership is available in official statistics non-state sectors. In order to isolate these (CSY 4-4, 4-7 and 4-8), as is the sectoral two effects, we can define an "agricultural distribution of rural collective employment labor reallocation effect" as (CSY 11-29). The sectoral distribution of rural and urban private and individual LREA EL / YMPLi - MPLAKIl (4) employment (CSY 4-2) is not available, but L iE =l,S/YjMPL a reasonable assumption is that this lies i=I.s primarily in the services sector.'