Redesigning the Dragon Financial Reform in the Peoples Republic of China

During the summer of 1995 the central government announced a series

of new banking laws would be established. These laws were the Peoples Bank

of China Law, the Commercial Banking Law, the Negotiable Instruments Law

and the Guarantee Law. Up until this time the roles of each party in the

framework of financial transaction hadnt been clearly defined. These

laws begin to lay the comprehensive groundwork for financial

transactions[25]. The Peoples Bank of China Law which was established in

the summer of 1995 addresses the internal organization of the Peoples Bank

of China, its monetary policy, its supervision and tries to establish its

autonomy from provincial and local governments (it is still under the

control of the State Council). This law has provisions in it for setting

the prime lending rate, rediscount window, amount of funds to be lent to

commercial banks, and the trade of treasury bonds, government securities

and foreign exchange. It also bars the Peoples Bank of China from

financing the budget deficits of the central government and local

governments. The Commercial Banking Law addresses the mission of

commercial banks. These are still under the guidance of the State Council

and still must issue policy loans (although the law also states that any

losses due to defaults on these loans will be compensated by the State

Council).

The Negotiable Instruments Law is similar to the United States

Uniform Commercial Code. The Guarantee Law deals with mortgages, pledges,

and liens. Both of these laws are hoped to standardize and regulate credit

transactions in the PRC[26].

Monetary Policy

Monetary policy in the PRC is currently administered through a

central credit plan. This plan, which is administered by the State

Council, sets credit quotas for each bank and also facilitates direct bank

financing of enterprises. In the current system the major objectives of the

specialized banks is to provide loans for various projects, agriculture and

foreign trade. The main recipients of these loans are the state owned

enterprises (SOEs). The terms and rates of these loans are very favorable

(usually 12%[27]). Therefore the demand for these loans is higher than the

supply and private companies have to rely on other sources. This can take

on various means and can often lead to underground lending operations.

The convertibility of RMB has also been undergoing changes. Prior to

January 1, 1994, there were two money systems in China. One for local use,

the other for foreigners. These Foreign Exchange Certificates (FECs) were

redeemable only in state operated stores and restaurants. Only higher level

officials were able to use these and most imported goods required the use

of FECs. Since doing away with FECs , RMB convertibility was relegated to

official swap shops[28]. Now, with the correct permit businesses can use

any large bank to exchange money. However, the government has also begun to

establish hard currency audits as well as trying to force businesses to use

the same bank for all of their transactions (a way of tracking how much

money is being exchanged). The new convertibility does meet IMF

requirements[29].

State Owned Enterprises and the Social Safety Net

As illustrated above, the banking system and state owned enterprises

are closely linked (see Table 7 in Appendix, page 24, for financing of

SOEs). According to Chinese government statistics, up to 20% of the debt of

state banks is bad debt. International estimates place this figure at

almost double that amount[30]. Recently in Jiangsu province, 30 SOEs

declared bankruptcy telling the banks they were not going to pay their

debts. If all the banks in China did this it would lead to bankruptcy of

the banks[31]. SOEs account for only 34% of industrial output but consume

73.5% of government investment[32]. Most have an average debt equal to 75%

of total assets[33]. According to an Oxford Analytica study, in the first

eight months of 1995, SOE industrial output expanded by only 8.3% compared

with a 13.7% increase for all industry. And according to estimates, non-

SOEs, on average, required less than a third as much investment to achieve

equivalent industrial output.[34]

These are serious problems. The ninth five year economic plan (1996-

2000) places priority on their eradication, calling for SOEs to lay off

workers to boost efficiency, and encouraging SOEs to declare bankruptcy if

their liabilities outstrip assets, if they make long-term losses and if

they lose out in market competition.[35] Up until now current reforms and

lessening of government controls have not only not reigned in this problem

but have also created new ones such as asset stripping of the SOE by

management, workers and local governments[36].

However, the central and local governments are still hesitant to shut

down even the most inefficient SOE. Currently, 7 out of 10 industrial

workers work in a SOE. The SOE provides not only a job but housing,

education, pensions, insurance and often energy sources and commodity shops

on site. The World Bank estimates that only 56% of total expenditure by

SOEs is actually on wages, the rest is on social spending[37].

Therefore, any reform involving the SOEs must also involve reform and

development of a social safety net. Pilot programs have been started where

local governments create pension pools and are putting aside payroll taxes

for education, health and unemployment benefits. It is also important to

note that the question of social security reform is being worsened by

additional factors. Population in the PRC is progressively growing older.

This phenomenon can be attributed to increase in life expectancy due to

better living conditions and the one child per family policy.

How Should Reforms be Implemented?

Due to the interconnectedness of these areas of society, many of

these reforms need to be implemented simultaneously. In May of this year

the World Bank published a Country Study[38] that attempts to address these

issues. The following are proposed reforms from this study.

1) Reduce the role of government in the directing of resources.

This over time would lesson the State Councils role in directing the

day to day functions of the banks and eventually do away with the credit

plan. Banks would be able to allocate resources appropriately and to set

their own interest rates.

2) Improve the Central Banks management of monetary aggregates.

This over time would improve the consistency of banking laws by

ensuring that they are used and would also remove policy lending from the

banks and put it into the budget where it should be. This would also allow

for the development of the Central Bank as an institution.

3) Transform state commercial banks into real commercial banks.

This step would help to free the banks from the current crises of bad

debt and allow them to loan money to the newly emerging private sector.

4) Improve governance, diversify ownership and lower subsidies for SOEs.

In the short term this would include implementing an accounting

system and independent audits, give autonomy to the managers, getting rid

of unviable businesses and restructuring those SOEs that can be.

5) Transfer social services to the government.

This would reduce the burden on newly restructured enterprises. Over

time this would allow for a national system to be implemented.

Conclusions

In comparison with other countries undergoing transition from

centrally-planned economic systems, China had the luxury of initiating its

reforms at a time when it faced no macroeconomic or serious political

crisis. It was able to adopt a two-track approach to economic reform:

China continued state control of existing enterprises while loosening

economic controls enough to permit growth of a new, nonstate sector. This

was possible in part because the inefficient state sector was a small share

of the economy, compared to most socialist nations.

Chinas reform experience thus far has been one of enabling reform,

allowing marketization instead of forcing privatization, getting

government to step out of the way of the flows of commerce. The results

have been good to excellent in the productive sectors, but the reform has

not yet succeeded in the fiscal and monetary sectors, which are the domains

of government. Here the government cant step out of the way; it must

build the proper tools and structures to manage these sectors.[39] It is

in these areas, and in the efforts to reduce administration, dismantle

SOEs, and provide an adequate social insurance system for displaced workers

and affected citizens that China faces its true reform challenges.

To further evaluate how far China has come down the path of economic

transition, we look to a definition of transition used by the World Bank,

which describes these three components:

Liberalization: freeing prices, trade and entry to markets from state

controls, while stabilizing the economy. Stabilization is an essential

component to liberalization.

Clarifying property rights and privatizing them where necessary. Requires

re-creating the institutions that support market exchange and shape

ownership, and especially the rule of law.

Reshaping social services and the social safety net to ease the pain of

transition while propelling the reform process forward.

Examination of the Chinese experience shows that liberalization has

taken place to some degree, though much reform of prices, trade and markets

is still to be done. However, privatization and the assignment of property

rights are still very undeveloped, and the most difficult parts of

transition ahead are dependent on a still-unachieved transfer of the social

safety net from enterprise-based to government control.[40]

Were China to continue to grow at the rates of the last two decades,

it would surpass the United States as the worlds largest economy in less

than twenty years. Though some tapering off in the growth rate is

expected, China, with its sheer size and dynamism, is emerging as one of

the worlds economic powers. The reform policy choices it makes during

this period of transition thus have not only domestic but international

significance, as Chinas domestic economic and social stability will be

felt internationally. The rest of the world has ample reason for assisting

China in seeing these reforms through peacefully. Opening of economic

activity within China and with the rest of the world will assist the

process of political liberalization within the country, and will provide

enhanced regional and global security.

Table 3. The Fiscal Situation in the Reform Period

Source: Wong, Christine P.W., Christopher Heady, and Wing T. Woo. Fiscal

Management and Economic Reform in the Peoples Republic of China. Oxford

University Press. Hong Kong: 1995, p.24.

Table 5. Government Budgetary Expenditures

Source: Wong, Christine

P.W., Christopher Heady, and Wing T. Woo. Fiscal

Management and Economic Reform in the Peoples

Republic of China. Oxford

University Press. Hong Kong: 1995, p.24.

Table 6. Composition of Tax Revenues

Source: Wong, Christine P.W., Christopher Heady, and Wing T. Woo. Fiscal

Management and Economic Reform in the Peoples Republic of China. Oxford

University Press. Hong Kong: 1995, p.24.

Table 7. Changing Role of the State

Source: Harrold, Peter. Chinas Reform Experience to Date. World Bank

Discussion Papers #180. The World Bank:Washington, DC. 1992.

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[1] Spence, Jonathan The Search for Modern China. London: W.W. Norton and

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[2] Harrold, Peter Chinas Reform Experience to Date, World Bank

Discussion Paper #180, 1992.

[3] Broadman, Harry Meeting the Challenge of the Chinese Enterprise

Reform, World Bank Discussion Paper #283, 1995.

[4] Lele and Ofori-Yeboah, Unraveling the Asian Miracle. Brookfield:

Dartmouth Press, 1996.

[5] World Bank Web Page , November 1996

(http://www.worldbank.org/html/extdr/offrep/eap/china.htm)

[6] Lele and Ofori-Yeboah Unraveling the Asian Miracle. Brookfield:

Dartmouth Press, 1996.

[7] Gao, Shangquan Chinas Economic Reform. Macmillan Press Ltd: London,

1996.

8 Wong, Christine P.W., Christopher Heady, and Wing T. Woo. Fiscal

Management and Economic Reform in the Peoples Republic of China. Oxford

University Press. Hong Kong: 1995.

[8] China Budget Hurt By Tax Arrears. Reuters Financial Service, 14

August 95.

[9] Reform of Chinas State-Owned Enterprises: A Progress Report of Oxford

Analytica. World Bank Web Page, November 16, 1996

(http://www.worldbank.org/html/prddr/trans/dec95/china.htm).

[10] Ibid.

[11] Hodder, Rupert. The Creation of Wealth in China: Domestic Trade and

Material Progress in a Communist State. Belhaven Press. London: 1993, p.

80.

[12] Wong, Christine. Chinas Economy: The Limits of Gradualist Reform.

in China Briefing, 1994, ed. by William A. Joseph. Westview Press.

Boulder, CO: 1994

[13] Stevenson-Yang, Anne. New Reforms and Taxes for 94, in The China

Business Review. U.S.-China Business Council. Washington, D.C.: January-

February 1994.

[14] Peck, Joyce, Peter Kung, and Khoon-Ming Ho. Enter the VAT, in The

China Business Review. U.S.-China Business Council. Washington, D.C.: March-

April 1994.

[15] China: Tax Policy Changes May Not Be Welcome to Companies, But Are

Good for China, in Global Economic Forum. Morgan Stanley & Co. Inc.

1995.

[16] Wong, Christine P.W., Christopher Heady, and Wing T. Woo. Fiscal

Management and Economic Reform in the Peoples Republic of China. Oxford

University Press. Hong Kong: 1995.

[17] IWR Daily Update. Vol. 2, No. 104, 25 April 1995.

[18] Harrold, Peter Chinas Reform Experience to Date World Bank

Discussion Paper #180, 1992.

[19] Mehran and Quintyn, Financial Sector Reform in China Finance and

Development, March 1996.

[20] Ibid.

[21] Tseng, W et al. Economic reform in China: A New Phase , IMF

Occasional Paper #114, November 1994.

The Chinese Economy: Fighting Inflation, Deepening Reforms World Bank

Country Study Washington, DC, May 1996.

[22] Ibid

[23] Xu, Dianqing China: Contradictory Measures Frustrate Bank Reform

Center for International Private Enterprise, Washington DC, 1995.

[24] Mehran and Quintyn, Financial Sector Reforms in China Finance and

Development, March 1996.

[25] Ibid.

[26] Xu, Dianqing China: Contradictory Measures Frustrate Bank Reform

Center for International Private Enterprise, 1995.

[27] Forney and Sender Ever So Careful: China cautiously extends the

renminbis convertibility Far Eastern Economic Review, July 4, 1996.

[28] Ibid.

[29] Passing the Buck Far Eastern Economic Review, October 10, 1996.

[30] Ibid.

[31] The Chinese Economy: Fighting Inflation, Deepening Reforms. A World

Bank Country Study May, 1996.

[32] Forney, Matt Trials by Fire Far Eastern Economic Review, September

12, 1996.

[33] Reform of Chinas State-Owned Enterprises: A Progress Report of

Oxford Analytica. World Bank Web Page, November 16, 1996

(http://www.worldbank.org/html/prddr/trans/dec95/china.htm)

[34] Macartney, Jane. Focus - China Unveils 5-Year Plan Low on

Initiative. Reuters Financial Service. March 5, 1996. Available through

Lexis/Nexis ASIAPC library, China file.

[35] Ibid.

[36] Ibid.

[37] The Chinese Economy: Fighting Inflation, Deepening Reforms. A World

Bank Country Study, May 1996.

[38] Wong, Christine. Chinas Economy: The Limits of Gradualist Reform.

in China Briefing, 1994, ed. by William A. Joseph. Westview Press.

Boulder, CO: 1994, p. 51.

[39] World Development Report Stresses Benefits of Sustained, Continued

Reforms. World Bank News, Vol. XV, No. 25. June 27, 1996.

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