Chapter 17 Views on Curbing the Current Round of Inflation in China

Manuel Guitián, and Robert Mundell
Published Date:
June 1996
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Peigan Gan

During the past 16 years, that is, since the implementation of reform and policies to open the Chinese economy, China has experienced four rounds of relatively serious inflation. The current round of inflation, which began in July 1994, was initially caused by the rise in the prices of food products. In 1994, the 12-month retail price index of the whole nation increased by 21.7 percent; the margin of increase was the largest in the past 16 years. Controlling inflation and stabilizing market prices have become the first priority of economic policymakers.

The rate of the current round of inflation is much higher than that in the industrial countries, slightly lower than in most developing countries, and much lower than in Russia and some Eastern European countries. China’s average inflation rate in the past 12 years was at a medium level of 12 percent. China and Russia as well as some Eastern European countries are in the process of transforming their highly centralized, planned economies into market-oriented economies, and all are handicapped, although to different degrees, by a weakening of central government finance. However, Russia and some Eastern European countries are suffering from macroeconomic instability, hyperinflation, and a sharp decline of output. To the contrary, China is experiencing sustainable economic growth, while the inflation rate is moderate. Some Western economists attribute this economic “miracle” to the successful agricultural reform; enormous amounts of rural and urban savings, which have provided large amounts of noninflationary funds for economic construction; the gradual economic reform, which limited sudden shocks to the economy; and the successful financial reform in particular. All these illustrate that, in the transition period, the Chinese Government has had some unique advantages and experiences in controlling inflation while being able to maintain macroeconomic stability.

To curb inflation more effectively, it is necessary to explore and reach a consensus on the causes of the current round of inflation and the resulting problems. The following are my personal views on the performance of China’s financial sector and the problems China faces in combating inflation in particular.

First, inflation is, in the final analysis, a purely monetary phenomenon. Under the currency standard, a price rise is caused by a currency devaluation, which results from a limited supply of goods being chased by an excessive amount of currency. It is generally acknowledged that the present round of inflation is caused by the excessive investment in fixed assets, the rapid increase of consumption funds, and the resultant excessive supply of money and credit. The most direct causes, however, are price adjustments of basic products undertaken by the Government; the poor harvest of some agricultural products caused by natural disasters; and the discretionary price increase effected by those who are engaged in the commodity distribution sector. Some people conclude that these events were the main causes of last year’s price hike and that the supply of money and credit was not excessive. Furthermore, they argue that to be successful in boosting economic development and alleviating the tight supply of capital, it is not wise for the central bank to adopt a tight monetary policy. In fact, money supply (M1) in China has grown at an abnormally high rate during the past several years. From 1991 through 1994, the growth rates, in percent, of GDP and M1 were as follows:


On the basis of these figures, a consensus can be reached that the current round of inflation in China is caused mainly by the abnormal growth of Ml over the past several consecutive years.

Second, the most important objective of monetary policy is establishing price stability. In the transformation from a planned economy to a socialist market economy, it is necessary to achieve price stability in order to maintain macroeconomic stability. A research report on China’s economic development indicates that, when GDP growth exceeds 10 percent, it is always accompanied by inflationary pressures. The overdraft from the People’s Bank of China that was used to finance the fiscal deficit before 1994 was not the main cause of the excessive credit supply, because the ratio of the fiscal deficit to GDP was held to 0.5–1.0 percent, and much of the “quasi-fiscal” burden was transferred to the state-owned banks. Therefore, the monetization of the fiscal deficit is the least important and least direct cause of credit expansion.

The excessive supply of money and credit is created mainly through lending by the People’s Bank of China to other banks, which, from 1986 to 1992, amounted to 24.1–29.7 percent of GDP. Therefore, strengthening the independence of the People’s Bank of China in implementing monetary policy, establishing price stability as the chief objective of monetary policy, and controlling the supply of money and credit have become critical for maintaining macroeconomic stability. The recently promulgated Law of the People’s Bank of China and its enforcement have laid the legal foundation for strengthening macroeconomic regulation and for further economic and financial development.

Third, large amounts of renminbi used to purchase foreign exchange were a new and significant cause of last year’s increased money supply. At the beginning of last year, reform was launched in China’s foreign exchange regime, with the unification of the exchange rate and the implementation of the buying and selling of foreign exchange. Trade and nontrade receipts increased tremendously, and the trade surplus for the whole year amounted to $5.3 billion. Including foreign direct investment, foreign exchange reserves at the end of 1994 reached $51.6 billion, an increase of $30.4 billion and 1.4 times over that of the same period of 1993. At the end of March 1995, foreign exchange reserves reached the record level of $58 billion. Although the sharp increase in reserves has strengthened China’s capacity for external payment, to purchase foreign exchange, the People’s Bank of China supplied an additional Y 284.3 billion. This contributed to the rapid increase of the money supply in 1994 and has become a new and significant cause of inflation. In an effort to control the current round of inflation, the large amount of renminbi that was issued should also be fully taken into consideration so as to alleviate inflationary pressure.

Fourth, China must deal prudently with the problem of the eroding quality of bank loans. The eroding quality of bank loans and interenterprise arrears have become increasingly serious. These problems must be dealt with thoughtfully because they have been extremely detrimental to the development of China’s financial sector. According to one estimate, overdue and nonperforming loans amount to more than Y 500 billion, accounting for about 20 percent of total loans. It is also forecast that a portion of overdue and non-performing loans will become bad loans. As a result of the acceleration of enterprise reform, some enterprises may go bankrupt this year. The state-owned banks, the largest creditors of the state-owned enterprises, will no doubt suffer great losses. However, no matter what means are used to compensate for the losses of state-owned banks, the central bank will ultimately shoulder the burden. This may become a new source of inflation and will require preventive measures.

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