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Financial reform in China: Complementing the economic reform

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1985
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Luc De Wulf

Over the past three decades China reorganized its economy on a socialist basis, basically relying on central planning combined with heavy investment to speed up its economic growth. National income grew impressively (a 6 percent average annual increase for 1953–79), but living standards did not improve nearly so fast, principally because a very large share of national resources had been used for investment, while agricultural growth lagged behind that of industry. By the late 1970s, however, there was growing realization that it was possible to improve living standards and growth performance simultaneously. Reform of the economic system was part of the answer. Its main theme was to emphasize indirect rather than direct economic planning instruments and to give the different actors in the economy greater incentives and authority to respond to these indirect instruments. No blueprint existed for the reformed economic system; authorities were determined to experiment, analyze the results, and try new avenues when needed.

The reform of banking and public finance is a crucial element in the overall reform process, since the authorities want to rely increasingly upon credit, interest rate, and taxation policies to guide the actions of state enterprises, local governments, and individuals. This article reviews the major changes that have taken place in these areas.

Money and banking

The scope of monetary reform can perhaps be best understood by first briefly outlining how the banking sector operated in China before 1979, and then indicating how it is expected to operate once the reforms have fully taken hold. This provides the perspective necessary to assess the current stage of the reform.

The pre-1979 period. Before 1979, monetary policy in China aimed at facilitating the implementation of the physical plan while maintaining financial stability. The budget and the banking sector each had its role. The budget provided state enterprises with investment funds plus a minimum amount of working capital in the form of grants. No interest was charged on these funds, since investment funds were rationed by the Planning Department rather than by interest rates. A requirement for repayment did not need to be specified, as the budget in any event had full claim to any and all funds generated by state enterprises. The banking sector, for its part, provided state enterprises with any additional working capital required. By providing only the marginal capital requirements, the banking sector had to ensure that enterprises had the necessary liquidity at their disposal, but no more. To do so it continuously monitored financial flows in the economy. Flows affecting the currency holdings of the household sector were followed particularly closely, since they could generate inflationary pressures in the market for consumer goods. Whenever these financial flows were excessive or misdirected, the banking sector had to bring this to the attention of the authorities responsible for taking corrective measures. The banking sector itself had no mandate to use credit or interest rate policies to correct the situation. In the absence of direct administrative controls over the household use of currency, the banks actively promoted household savings in order to limit the currency in circulation.

Goal of banking reforms. In line with the greater responsibility given to indirect policy instruments in the allocation of resources, the banking sector is to be assigned two new related tasks. First, the central bank will have to assure the macrofinancial balance; using its monetary policy instruments, it will have to guide specialized banks to engage in credit activities that are consistent with overall financial stability. Second, within this framework of macrofinancial balance, credit policy will have the role of stimulating efficiency in resource allocation; specialized banks will be free to extend or refuse credit and vary interest rates solely on the basis of financial considerations. Obviously, credit policy will come to affect resource allocation in a way that it did not prior to 1979.

Current reforms. As a first step in the pursuit of these macrofinancial and credit objectives, the banking system was gradually restructured in 1979–84. In a first stage, the Agricultural Bank of China was revived, while the Bank of China was granted greater operational flexibility and responsibility in financing foreign trade and supporting the export sector. The Capital Construction Bank of China, which thus far had acted only as a fiscal agent for the Ministry of Finance, assumed banking functions for enterprises engaged in investment. More important, a central bank was established on January 1, 1984. The People’s Bank of China (PBC), which until then had fulfilled the role of both a central bank and a commercial bank in the urban areas, became the central bank, while its commercial functions were given to the newly established Industrial and Commercial Bank. At the same time the specialized banks were charged with overseeing the adequacy of all working capital of the state enterprises, irrespective of whether this capital was provided through the budget or through the banking sector itself. Banks have also begun to provide some investment loans. In addition, the budget, which in recent years included drastic cutbacks in the supply of working capital to the enterprise sector, now provides some investment funds in the form of loans rather than grants.

With the new structure of the banking system in place, monetary policy in China is designed to operate at two different levels. First, interventions are required to ensure the macroeconomic balance; these pertain to the relations between the PBC and the specialized banks. Within the framework of expected output and price developments, the PBC establishes an overall credit plan, which includes credit provided to the specialized banks. The implementation of the credit plan relies on regulations defining the deposit base of the specialized banks, deposit requirements, and rediscount rates. All government accounts are to be held at the PBC, while other deposits are to be made with the specialized banks. Specialized banks must in turn deposit 10 percent of their deposits with the PBC. When combined with those governing government account deposits, these requirements ensure that the PBC has direct control over about 30 percent of the total deposit base. Specialized banks can supplement their loanable funds by borrowing from the PBC; the rates on such borrowing are 4.7 percent a year for lending up to the limit set in the credit plan and 5.04 percent for temporary borrowing in excess of that limit. These rates are higher than the 4.3 percent annual return that banks receive on their deposits with the PBC; the differential is intended to discourage specialized banks from borrowing from the PBC.

Second, specialized banks rely upon policy instruments to ensure that their credit and deposit policy is consistent with the PBC’s macroframework. To enable them to remain within their credit limits, the specialized banks are given greater discretion in their lending. Creditworthiness of projects is to receive greater emphasis than in the past, with bank managers given greater latitude to withhold loans to enterprises that operate with excessive working capital. This, of course, requires a shift in authority away from the enterprise manager and the planning department to the bank manager, for whom an especially designed incentive system is being set in place. To assist the bank manager in rationing credit, interest rates on bank loans have been increased; rates on working capital loans, for instance, have been increased from 5.04 percent in 1979 to 7.2 percent in 1985. Furthermore, the bank manager is empowered to vary within certain margins the interest rates charged. A 20 percent surcharge, for instance, can now be levied on enterprises that operate with excessive working capital, while a 20 percent discount can be granted to enterprises that improve their use of working capital.

With banking instruments now apparently in place, the implementation of a more active monetary policy appears possible. This should permit the indirect policy instruments gradually to assume a more important role in economic policy. Several structural factors in the Chinese economy, however, still complicate the task of implementing a more active monetary policy that would ensure macroeconomic balance and efficient resource allocation. Briefly, these factors are the distorted price structure, the still large scope of mandatory planning, and the fact that enterprise reform is not yet completed.

As long as price distortions remain, it will be difficult for bank managers to decide which credit requests are justified on economic grounds. Since profitability is not yet a reliable guide and to the extent that large sectors of the economy are still under the mandatory plan, there is the risk that the credit required to make the production under the mandatory plan possible, or to permit the overfulfillment of these plan targets, will exhaust the credit that a specialized bank can grant in a particular area. This could either starve the other sectors of the economy of needed credit or generate pressures for additional PBC credit. While the latter would lead to the breaking of the credit plan and cause macroeconomic imbalance, it may prove difficult to withhold credit from the sectors that operate outside the mandatory plan and that in recent years have grown faster than the planned sectors. Establishing and enforcing, within the overall credit plan, credit limits for the planned sectors would be one way of ensuring sufficient credit to those sectors that fall outside the mandatory plan.

With enterprise reform still incomplete, and profit maximization not yet receiving sole emphasis, managers must often satisfy a multiplicity of goals, including the fulfillment of quantitative output targets and the provision of employment. They often share the de facto responsibility of running the enterprise with other officials. As such, the inflated demand for credit that prevailed in the past may continue and the enterprise response to interest charges may be weakened. For the moment indirect monetary policy instruments may need to be supplemented by quantitative controls.

Government finance

The economic reforms initiated in 1979 emphasized the devolution of power to lower-level entities and the provision of greater incentives based on indirect or market-related mechanisms. In public finance this came to mean that the hitherto highly centralized fiscal relations between the central and local governments were to become less so, and that the tax system would be adjusted to provide an adequate incentive structure.

Intergovernmental fiscal relations. Before 1979 there were no clear-cut definitions of responsibility for administering local and central expenditures and raising the necessary revenues. The central government looked upon revenue from the different budgets as one big pool, which it then allocated to either the central or local budgets. In the absence of objectives for income redistribution among local jurisdictions, these transfers were guided by historical relations and ad hoc measures. This approach to budgetary policy, which was later characterized as “eating out of the big pot,” undermined the revenue efforts of local authorities and led to expenditure waste. In addition, it did not give local authorities the needed flexibility to respond to emerging local needs and it inhibited multiyear fiscal planning.

The 1980 reform of intergovernmental fiscal relations was to change this situation, and a method of “separate kitchens” was instituted. Different jurisdictions were assigned expenditure responsibilities and revenue sources, and were made responsible for the outcome of their budgets. Local governments whose expenditure exceeded revenue could use a part or all of the revenue from the commodity taxes to make up the difference; in the case of the poorest local governments the central government was to make actual transfers. For those local governments whose revenue exceeded expenditure, some excess was to be channeled back to the central government. Hence, a custom-tailored revenue and expenditure-sharing formula for each local government, approximating the fiscal relations that existed before the reform, was set in place. One major difference, however, was that the new rules were to remain in effect for five years (i.e., until 1985), and those jurisdictions that raised more revenue than budgeted could keep the increase, which provided a powerful incentive to raise their revenue effort.

However, in line with the announced flexibility in the reform and the intention to learn from experience, the system underwent several modifications. First, with the rapidly growing expenditure responsibilities for the central government (mainly as a result of the rapid increases in subsidy expenditures), the sharing formula for budgetary revenue proved rather overgenerous to local governments. In the first two years of the reform, many local governments ran surpluses, while the central government ran deficits, prompting the central government to borrow from the local governments—without interest or fixed repayment obligation—Y 11 billion, or 4 percent of total 1980-81 budgetary revenue. On the other hand, some local governments argued that the revenue-sharing formula was inadequate, as it left them with the slow-growing portion of the revenue structure, and pressed for a new and more generous sharing formula. Second, because the supervision and ownership of some enterprises was transferred between jurisdictions, the revenue-sharing formulas established in 1980 had to be adjusted. As a result the revenue-sharing formulas were revised in 1982, in some cases substantially, while formulas that determine the transfer of funds from Beijing, Shanghai, and Tianjin, the major contributors to the central government revenue, are reviewed annually.

A new reform of the fiscal relations between the central and the local governments was under way in early 1985. In his speech at the Third Session of National People’s Congress, Minister of Finance Wang Bingqian announced that beginning in 1985 each jurisdiction would be assigned its own revenue source, while the revenue from some taxes would be shared between the jurisdictions according to a ratio that would remain unchanged for five years. The specifics of this reform, however, were not available at the time this article was written.

Tax reform. Tax reform is an integral part of enterprise reform, which is intended to provide state enterprises with greater incentives and to increase their efficiency. The focus of tax reform has thus been on the taxation of enterprise profits, but commodity taxes have also recently been affected. To appreciate the complexity of tax reform in China it is important to understand the constraints imposed by the present distorted price structure. Because prices often do not reflect demand and supply forces, but are inherited largely unchanged from earlier periods, they often provide generous subsidies on the production of some commodities and cause losses from the production of others, irrespective of efficiency. Under these circumstances, it was intended to use variations in the tax rates to prevent enterprises from retaining artificially high profits resulting from the distorted price system. (Under the previous system, this equalization occurred through the remittance of different proportions of the profits to the budget.) All this makes for a rather complex tax system, a system that can only be simplified when progress is made with price reform. Hence, probably more so than with any other aspect of the reform, tax reform will be an ongoing process, and tax rates for individual enterprises and products will have to be adjusted continuously.

A major element of the tax reform since 1979 has been the replacement of the system under which a state enterprise handed over all its revenue to the budget, first by profit sharing and then by an income tax. As early as 1979, experiments permitted selected enterprises to retain part of their profits and remit only the remainder to the central government. While this system of profit sharing was gradually extended to more state enterprises, experimentation with income taxation took place. A variety of schemes were tried out; some specified progressive rates, while others combined a flat tax rate on profits with a fixed tax rate on assets. Most schemes permitted state enterprises to pay a lower tax rate on profits that exceeded those of the reference year, while some schemes stipulated that enterprises could retain 100 percent of the profits in excess of some contracted amount. A promise that the income tax system would not be changed for several years was also provided.

The results of these experiments were closely monitored, and by 1983 China decided to proceed with a general tax reform. The major objectives of this reform were to (1) ensure that in the medium term the budget obtains the larger share of the profits (the profit-sharing system had given state enterprises too large a share of the total profits), (2) provide an incentive to enterprises to increase their productivity, (3) clearly establish the independence of the enterprises vis-à-vis the various supervisory government organizations, and (4) speed up the payment of taxes by providing clear instructions on the computation and payment of tax liabilities.

The reform was implemented in two steps (July 1983 and October 1984) and affected several taxes. First, all state enterprises are now required to pay income taxes. Large enterprises first pay a 55 percent tax and apply a regulatory tax to the after-tax profits. This regulatory tax differs among enterprises, largely to offset the impact of the distorted price structure on enterprise profitability, and is levied according to a variety of systems. The new profit tax scheme ensures that enterprises retain approximately the same amount of profits as in 1982, if profits are unchanged, but permits the retention of a larger share of any increase in profits. Small enterprises are taxed according to a progressive scale, but may be liable to additional taxation if the after-tax profits are higher than is considered “rational.”

Second, the value-added tax, which had already been experimented with in some sectors, was applied in several other sectors, while the existing industrial and commercial tax was turned into a product tax, with higher rates on products produced with high profits and lower rates on products produced at lower profits, and a business tax on the service sector. On balance, the reform of commodity taxation has increased the commodity tax burden, which will cause a future lowering of the “adjustment taxes” levied on after-tax profits. Third, a graduated resource tax was introduced to tax the profits of enterprises engaged in the exploitation of natural resources, and whose profitability is enhanced by the availability of superior resource endowment or communication facilities. Fourth, the local tax base was strengthened by introducing a surtax on the commodity taxes, in addition to the existing urban property, land use, and the vehicle taxes.

An ongoing process of tax reform. As of 1985, China has a more distinctly defined tax system than it had before. The system remains very complex, however, largely because taxes have to offset a distorted price system. Price reform therefore will greatly assist in the establishment of an efficient tax system. In addition, if experience in other developing countries can offer any guidelines, four other elements may also be important.

First, if deficit financing and its destabilizing effects are to be avoided, budgetary revenue is likely to have to increase at the same pace as expenditures. Even if budgetary expenditure does no more than maintain its present share of gross national product (unlike the experience of many countries that saw this share growing during the process of development), revenues would need to increase at least as fast as the gross national product. This requires that the budget maintain its share in the profits of the enterprise sector and that those sectors of the economy that grow fastest be effectively taxed. The recent introduction of the enterprise income tax will likely assist the Government in achieving the first objective, while effective taxation of the fast-growing branches of agriculture—where tax burdens have fallen in recent years—and the individual economy may require greater attention.

Second, taxation is generally more effective when it neither favors nor penalizes production or consumption activity, unless such discrimination is specifically intended. In reality, all tax systems contain many non-neutral elements, at times for good reasons. To ensure that deviations from neutrality serve intended purposes, a review of all elements of the tax system that are discriminatory (e.g., different rates of product tax and customs duties, and different adjustment rates after the income tax is paid) would be useful. Some will survive the test (to meet income distribution goals, for instance, or to compensate for the distorted price system), but others will not and it may be advisable to eliminate these.

Third, if economic agents can predict the incidence of taxation, they can adjust their activities in accordance to the tax liability they will incur. During a period of tax reform a degree of uncertainty is unavoidable. It is generally preferable, however, to assure all economic agents as soon as possible that their tax liability will be computed according to a system that will remain in effect for an extended period, so that taxation can fulfill its role as indirect planning instrument.

Fourth, efficiency is a critical element in the effectiveness of a tax system. Efficiency is often most readily attained when taxes are easy to levy, when their objectives can be achieved in as simple a fashion as possible, and when disputes between the tax authority and the taxpayer can be minimized. This, in turn, argues for a simple tax system, with clear rules. China’s new tax system goes some way toward this ideal; but, as is true for other countries, tax reform is by its own nature a gradual and continuous process.

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