Front Matter

Front Matter

Manuel Guitián, and Robert Mundell
Published Date:
June 1996
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On page 129, the matrix for demand and population should read as follows:


Proceedings of a conference held in Beijing, China May 10–12, 1995

Manuel Guitián

Robert Mundell


International Monetary Fund

Washington, 1996

© 1996 International Monetary Fund

Design and production: IMF Graphics Section

Library of Congress Cataloging-in-Publication Data

Inflation and Growth in China: proceedings of a conference held in Beijing, China, May 10–12, 1995 / Manuel Guitián, Robert Mundell, editors.

  • p. cm.

Includes bibliographical references. (p.).

ISBN 1-55775-542-6

1. Inflation (Finance)—China—Congresses. 2. Monetary policy—China—Congresses. 3. China—Economic policy—1976—Congresses. 4. Inflation (Finance)—Asia—Congresses. 5. Monetary policy—Asia—Congresses. 6. Asia—Economic policy—Congresses. I. Guitián, Manuel. II. Mundell, Robert A. III. International Monetary Fund. HG1285.G76 1996




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There is now a broad consensus that monetary stability is a precondition for sustained growth. A lasting expansion of output cannot be realized in an inflationary environment; on the contrary, if the growth of output is to be maintained on a sound path over time, inflation must be brought down to levels consistent with a reasonable measure of price stability. This issue is highly relevant to China’s economy, which has grown rapidly in a setting where inflation has emerged as a major problem. It is commendable that the Chinese authorities, as part of a comprehensive reform program, have paid particular attention to this problem and are committed to bringing inflation under control.

In this context, the Chinese authorities have recently undertaken a wide-ranging revision of the statutes and laws regulating the operations and responsibilities of the People’s Bank of China and the financial system as a whole. The new Law of the People’s Bank of China embodies the principle that price stability is the primary responsibility of monetary policy. The People’s Bank of China has been given the instruments and the operational autonomy to pursue this objective.

The IMF is pleased to have been associated with China in the effort that led to the publication of this volume, which represents the institution’s continued collaboration with China. It brings together the proceedings of a conference on inflation and growth in China, which was held in Beijing on May 10–12, 1995. The conference was organized by Professor Robert Mundell of Columbia University and included among its sponsors the People’s Bank of China and the IMF. The discussions benefited from the participation of senior central bank officials, academics, and IMF staff. The exchange of views was stimulating, constructive, and, indeed, enriched by having contributors from many different countries. I am grateful to all those who, inside and outside the IMF, contributed to the success of this conference. I very much hope that this volume will convey to a wide audience the importance of achieving growth without inflation.

Michel Camdessus

Managing Director

International Monetary Fund


The conference on inflation and growth in China brought together a number of academic luminaries, distinguished officials from many different countries, and IMF staff members to focus on the relationship between inflation and growth, a subject of perennial interest and debate. The IMF’s Monetary and Exchange Affairs Department was invited to play an active role in organizing the conference because of its extensive program of technical assistance to member countries, including China, to improve their ability to implement effective monetary polices and develop sound banking systems. In addition to monetary and exchange rate policies, the conference discussions covered other critical areas of economic management, including fiscal, agricultural, and environmental policies, all of which are ingredients of a policy mix that is effective in ensuring sustainable growth.

Against the background of experiences from other countries, China’s reform program was examined in detail, and the papers in this volume allow readers to draw inferences about the existence and sustainability of a trade-off between inflation and growth. The cross-fertilization that resulted from bringing together these different experiences enriched the conference discussions immeasurably.

I wish to express my personal gratitude to Professor Mundell, whose intellectual leadership of the conference represented a major contribution to its success. I am pleased indeed to have been associated with him in the organization of the conference and the publication of its proceedings.

Within the IMF, many of my colleagues contributed to the successful completion of this volume, but in particular I wish to thank Elisa Diehl of the External Relations Department for editing the papers for publication and managing the production process and Charmion O’Connor of MAE for her secretarial assistance.

Manuel Guitián


Monetary and Exchange Affairs Department



Robert A. Mundell

In the spring of 1995, while preparing for a term teaching at the People’s University of China in Beijing, I organized a conference for the People’s Bank of China (PBC) on inflation and growth. The seminars took place in Beijing, China, on May 10–12, 1995, with financial support from the IMF, Citibank (China), and the Deutsche Bank Group. This volume is an outgrowth of that conference. I would like to take this opportunity to acknowledge the contributions of several individuals to the conference in Beijing and the publication of the book. Thanks are due to Yuan Chen, Deputy Governor of the PBC, for his contribution and hospitality and to Zhixiang Zhang, then-Director of the International Department of the PBC. I am grateful to Chung Ping Cheng and John Law of Citibank China and to Norbert Walter of the Deutsche Bank Group for early financial support and encouragement. Ranier Adam of the Friedrich Naumann Foundation in Beijing gave timely advice and logistical support. Hongyi Chen contributed tireless assistance and valuable liaison work with the IMF and the PBC. Valerie Natsios was indispensable throughout the planning stages of the conference and in the preparation of materials for the book.

The juxtaposition of “inflation” and “growth” was very relevant to China’s economy in 1995. While growth was continuing at a rapid pace, increasing inflation had emerged as a major problem. During 1992–94, the rate of inflation, as measured by the increase in the consumer price index, rose from 6.4 percent in 1992 to 14.7 percent in 1993 to 24.1 percent in 1994. Over the same three years, economic growth reached 13 percent a year, one of the highest sustained growth rates in the annals of economic history. A major problem for the conference was to consider how inflation could be reduced without drastically lowering economic growth.

In choosing subjects for analysis, I thought it appropriate to strike a balance between papers relating to international experiences with inflation and growth, long-run and short-run structural problems related to growth and inflation in China, and the framework in which monetary, fiscal, and exchange rate policies are formulated in China. The 18 papers in this collection therefore fall conveniently into three parts. Part I focuses on inflation and growth in countries whose experiences may contain lessons for China; Part II addresses the problem of sustainable growth and structural reform within China; and Part III focuses on China’s monetary and exchange rate policies. In this introduction, I first present an overview of key aspects of China’s economic policies in the reform era and then review the highlights and conclusions of the papers.

China’s Growth Miracle

China’s economic growth in the Deng Xiaoping era has been remarkable. Growing at an average rate of 9.2 percent since 1978, and at 12.1 percent over the past four years, the Chinese economy has set new growth records. Even more remarkable has been China’s trade, with exports rising 14-fold, from $10 billion in 1978 (0.8 percent of world exports) to $148.8 billion in 1995 (almost 3.5 percent of world exports).1 International reserves in early 1996 topped $75 billion.

Like most growth “miracles,” China’s has been associated with the shift of labor from low-productivity agriculture to high-productivity industry, combined with rapid urbanization, absorption of foreign technology, and a favorable age distribution of the labor force. The period of supergrowth ends when bottlenecks, such as the supply of labor, appear. But in China, this bottleneck is a long way off. Two-thirds of the labor force is still in agriculture, and there are over 150 million surplus workers in the countryside. China will run out of water before it runs out of people.

The supply of capital could become a bottleneck unless saving keeps up. But in China, saving, spurred by the household sector, increased from 30 percent of GDP in 1978 to 40 percent in 1994. The population policy, limiting families to one child, has deprived adults of their traditional social security system and forced households to save. Household saving soared from 18.6 percent of total savings in 1978 to 71.5 percent in 1993, with no signs of abating. Moreover, technology-intensive capital is available from abroad, with direct investment of $28 billion in 1994 and $37 billion in 1995. This has fed the booming capital-intensive export-oriented coastal regions to which Deng Xiaoping gave his blessing in his 1992 tour of southern China.

This is not to say that supergrowth can be taken for granted or will continue indefinitely. Neglect of important sectors of the Chinese economy has created bottlenecks in communication, energy, transportation, and financial management. These key industries have thus far been exclusively reserved for the public sector, where a major problem exists with the structure and efficiency of state enterprises.2 In contrast to the booming private sector, which grew at an annual average rate of 38.5 percent from 1990 to 1994, the state sector expanded only 7.1 percent over the same period. As a consequence of slower growth of the public sector, the share of industrial output accounted for by state enterprises fell from 80.7 percent in 1978 to less than 40 percent in 1995.

The solvency of state-owned enterprises, more than half of which make losses, presents a major problem. Instead of losses forcing cost-cutting adjustments or bankruptcies, the typical state-owned enterprise has been kept in business with infusions of credit from the banking system. The result has been that the debts of firms have mounted, building up a chain of interfirm indebtedness.3 A major stumbling block to reform of the state enterprises has come from managers and workers with vested interests in the security of their jobs and pensions.

In the early years of the reform era, agriculture, liberalized in the early 1980s when the household responsibility system replaced the commune system, was the showpiece of China’s reform strategy, and it resulted in a grain surplus, albeit a temporary one. But since 1985, infrastructure in the rural sector has been neglected and production has stagnated. When in 1993 inflationary expectations increased, fanners hoarded grain and market supplies fell. The authorities reacted to the resulting rise in prices by reimposing some price controls. Recently, the Government has re-emphasized agricultural reform and has placed an increase in grain production at the top of its agenda.

The decontrol of prices in the mid-1980s, combined with rapid monetary expansion, brought into the open an inflation problem. Since 1985 the inflation rate has twice risen to dangerous levels, in each case requiring a major shift in policy. In the late 1980s, credit restriction and a drop in fixed investment succeeded in slowing inflation, but it created a severe growth recession. When growth was restored to two-digit rates in the early 1990s, inflation again became a subject for serious concern.

The Inflation Problem

The inflation problem of the past decade does not represent an inflationary tradition in modern China. After the 10,000:1 currency reform in 1952, Chinese monetary policy, until the mid-1980s, was admirably stable. From 1953 to 1984, inflation in China was lower than in even the most stable Western countries.

From 1953 to 1959, inflation averaged about 1.5 percent; this corresponded to an average (but erratic) recorded growth rate of 10.7 percent for the period. Over the next three years, during the famine of the “Great Leap Forward,” output fell by one-third and prices rose 24 percent. But for the next decade the price level actually declined at an average rate of 1.5 percent, almost restoring the pre-famine price level, while growth averaged 10 percent. From 1973 to 1984, when Western countries were experiencing two-digit inflation rates, prices in China rose only by an average of 1.5 percent, while growth averaged 7.7 percent.

It should not be overlooked, of course, that general price controls existed before the mid-1980s. Measured inflation rates under a system of price controls do not accurately reflect the true rates of inflation, much of which is repressed. Over this early period, China’s economy was characterized by excess demand, shortages, and a monetary overhang. With the lifting of price controls, therefore, prices would have increased even in the absence of additional monetary expansion. For this reason, comparison of recent inflation with that of earlier decades is not strictly valid.

An important change in the inflation situation occurred in 1985, when several prices were liberalized at a time when credit was expanding rapidly. During 1985–87, prices rose an average of 7.4 percent while the money supply was rising at an average rate of 23.2 percent. The following two years were more alarming. When further decontrol measures were implemented in 1988, prices soared by 18.5 percent in 1988 and 17.8 percent in 1989. Two years of back-to-back inflation of more than 15 percent created a sense of panic and the beginning of a run on bank deposits.4

Forced to act, the Government tightened monetary conditions, reduced investment, scrapped further decontrols, and postponed the projected elimination of the two-tier pricing system. The money supply expanded by only 6.3 percent in 1989, and investment increased by only 1.2 percent in 1990.

The economy responded sharply to these measures: inflation came down to 1.4 percent in 1990 and to 5.1 percent in 1991. The inflationary scare of 1988 and 1989 was calmed and macroeconomic balance was restored. But the disinflation measures had a high cost in terms of economic growth, which, from its extraordinary average of 11.5 percent over 1983–88, plummeted to 4.3 percent in 1989 and 3.9 percent in 1990 (see Table 1).

Table 1.Inflation, Growth, Money, and the Exchange Rate
Nominal GDP23.113.616.724.513.710.514.220.728.833.625.1
Exchange rate
(yuan/U.S. dollar)2.943.453.723.723.774.785.325.515.768.628.44

Costly as the recession was in terms of growth, it brought in its train an important change in the macroeconomy. For the first time, firms in the new China had difficulty selling outputs and had to compete for markets by lowering prices. The slowdown thus had the salutary effect of ending the era of the shortage economy and introducing a better framework for macroeconomic stability.

Recovery came in 1991. Investment grew by 18.8 percent and GDP growth recovered to 8 percent. The expansion continued at an even more rapid rate in 1992 and 1993, with investment increasing by over 28 percent and 22 percent, respectively. The economy heated up, with growth in 1992 and 1993 reaching the heady rates of 13.6 percent and 13.4 percent, respectively. The economy was once again in a supergrowth boom.

Once again, the resumption of supergrowth and easy credit brought a cost in terms of a resumption of inflation. After averaging less than 5 percent for two years, the inflation rate increased to 6.4 percent in 1992 and 14.7 percent in 1993. Rapid investment was again being financed by the banking system. The money supply expanded by 20.1 percent in 1990, 28.2 percent in 1991, 30.3 percent in 1992, and 21.6 percent in 1993.

The year 1994 began with an auspicious change in exchange rate policy. On January 1, 1994, China announced steps to unify its exchange rate and establish “conditional” current account convertibility. At the same time, it raised the renminbi price of the dollar from Y 5.8 per US$1 to Y 8.4 per US$1, a devaluation of almost 45 percent. This devaluation, achieved in moving to a de facto floating system, was a boon to export markets and helped maintain the export-led growth boom. But it also aggravated inflationary pressures. Devaluation raised prices directly through its immediate impact on export and import prices, and indirectly through the central bank purchase of foreign exchange, which increased the reserve base of the monetary system. Largely impelled by central bank purchases of foreign exchange reserves, the money supply expanded by over 30 percent in 1994 and consumer prices rose an alarming 24.1 percent.

Again, the Government had to take corrective action. There were two points of view. On the one hand, insofar as the exchange rate change undervalued the renminbi, it could be argued that the inflationary potential of the renminbi had been largely dissipated by the subsequent rise in prices in 1994; according to this view, inflation would subside of its own accord even without a change in current monetary policy as the surplus in the balance of payments was being brought under control. On the other hand, the extraordinary rise in prices carried with it the threat that it would raise inflationary expectations and bring about another flight from money. Because the inflation threat seemed more urgent, the authorities decided to tighten. Credit expansion was reduced and investment was curtailed; the money supply, which had increased by 30.4 percent in 1994, was held to 24.6 percent in 1995.

These measures were rewarded with significant success. The three major inflation indices turned down in 1995.5 The rate of increase of consumer prices was reduced from 24.1 percent in 1994 to 17.1 percent in 1995; the increase in the retail price index came down from 21.7 percent in 1994 to 14.8 percent in 1995; and the increase in the GDP deflator fell from 19.5 percent to 13.5 percent. Growth fell, but only slightly, to 10.2 percent. Some early reports from the opening months of 1996 suggest that inflation may be close to the single-digit category. If so, the stabilization plan will have proved to be a success.

China’s promising economic prospects in the world of Asian and world finance make its exchange rate policy a matter of exceptional importance. The renminbi had been held in the range of Y 1.5–2.5 per US$1 for three decades before the 1980s. After 1985, even though the dollar depreciated against other major currencies, the renminbi started to depreciate against the dollar, which reached an average of Y 3.7 in 1987, Y 4.7 in 1989, Y 5.8 in 1993, Y 8.6 in 1994, and Y 8.3 at the end of 1995. The problem for macroeconomic management in the future is to coordinate monetary, fiscal, and exchange rate policy to prevent residual inflation from generating, with a stable renminbi, the syndrome of overvaluation.

China’s high level of reserves and strong external surplus position in a framework of flexible exchange rates raise questions about the currency composition of its reserves, particularly the balance between holdings of U.S. dollars and yen. There are of course persuasive arguments for keeping a high proportion of dollars in reserves. But there are also arguments, valid over the long run, for keeping a substantial share of yen in China’s reserve portfolio. Needless to say, the time to diversify into yen is when the yen is low against the dollar, not high. When the time is right, however, it would be in China’s interest to optimize its holdings of dollars, yen, deutsche mark, and gold along the lines of modern portfolio theory.

China has much to gain from further movements toward financial liberalization. In 1994, China took a big step toward current account convertibility and unification of the exchange rate. Further steps in the direction of full convertibility of the renminbi and greater liberalization are now made possible by the strong external payments position and bulging foreign exchange reserves. China’s goal of full convertibility by the year 2000 can best be achieved through continued efforts to keep the inflation rate at low single-digit levels.

Inflation and Growth

Part I of the book incorporates papers that develop guidelines for the management of inflation and growth, drawing on international experiences. It includes the following papers: Manuel Guitián, “Inflation and Growth: Is There a Trade-Off?”; Norbert Walter, “Inflation and Growth in a Country in Transition”; Arnold Harberger, “Fiscal Deficits and the Inflation Process”; Emil-Maria Claassen, “Growth and Inflation in Asia’s Transition Economies”; Muthi Samudram, “Growth and Inflation in Malaysia”; and Robert Mundell, “Inflation and Growth in the Transition Economies.”

Manuel Guitián, Director of the Monetary and Exchange Affairs Department at the IMF, discusses the linkage between inflation and economic growth. Theoretical and empirical evidence, he states, supports the conclusion that low and predictable inflation is conducive to growth. The experiences of African, Asian, and Latin American economies, he says, hold four lessons.

The main lesson from experience is that persistent inflation may reduce growth prospects. Long-term growth requires a high level of investment and therefore domestic saving; both saving and investment are likely to be fostered by low and predictable inflation. Nevertheless, short bursts of inflation are sometimes difficult to avoid, for they are the consequences of a necessary devaluation, price liberalizations, or structural reforms, as may have been the case in China. However, such a temporary increase in inflation should not lead to continuous inflation, provided that inflationary expectations do not increase and that the Government’s commitment to low inflation is clearly established.

A second lesson is that low and predictable inflation is a necessary but not sufficient condition for fostering growth. The experience of some African countries, although successful on the inflation front, shows that a resumption of growth also requires improvement in external competitiveness and the implementation of structural reforms. A third lesson is that flexibility in adjusting quickly to the fiscal and monetary problems that macroeconomic shocks cause is crucial if growth is to be sustained. Countries often experience external or internal macroeconomic shocks, but a lack of adjustment may result in high inflation, an overvalued exchange rate, and a balance of payments crisis, which, in turn, lead to low investment and growth.

Finally, the difficulties in reducing inflation in some countries are related to the fact that their economies have adapted to living with high inflation. Although there may be agreement on the necessity to reduce inflation, there is disagreement on how to cope with it, in particular, on the distribution of the cost of reducing inflation. Nevertheless, learning to live with inflation is clearly not a sustainable solution. Inflation in the double digits, or in the upper single digits, serves no useful purpose and, as experience has shown, it often starts a tendency to rise further. It should, therefore, be fought and reduced.

Norbert Walter, Chief Economist of the Deutsche Bank Group, addresses the issue of a stability-oriented monetary policy in a transition economy. He starts off with the observation that China’s first central bank legislation, which was adopted in March 1995, charges the People’s Bank of China with conducting the country’s monetary policy but does not provide a precise definition of the central bank’s duties and responsibilities. Price stability, he argues, is a cornerstone of the transformation process, because its absence deprives markets of the all-important function of signaling scarcity relationships in the economy.

The first victims of inflation are all savers, with the brunt of monetary depreciation being borne by small savers. The same applies to savings held in cash. Negative real interest rates—where nominal interest rates are lower than the inflation rate—also reduce the purchasing power of interest income and thus the incentive to accumulate capital.

The normal reaction of savers is to switch to higher-yield investments or physical assets—real estate, precious metals, jewelry, works of art, consumer durables, and the like. Switching to physical assets artificially drives up prices in these sectors and feeds inflation, which impairs the signaling function of prices and distorts production structures. A typical example is overinvestment in construction, only to be followed, in a subsequent phase of tight money, by empty buildings and an increase in problem loans by banks.

Walter analyzes the relationship between monetary and fiscal policy and concludes by stressing the need to coordinate monetary policy with other political groups in the economy, including unions, employer associations, and the banking system.

Arnold Harberger, Swift Distinguished Service Professor Emeritus of the University of California at Los Angeles and 1996 President of the American Economic Association, begins his paper with an examination of the costs of inflation arising from the blurring of signals from the price system. After distinguishing between inflationary and noninflationary budget deficits, and the problem raised by the complex of different interest rates, he discusses the nature of the inflation tax and the extent to which it reduces credit going to the private sector. He attacks the real bills doctrine, recounts the experiences of several Latin American countries with fiscal deficits, and develops the formula for determining the budget deficit that can be financed by money creation without serious risk of inflation; in his judgment, borrowing to finance budget deficits should be kept within 1 percent of GDP. Harberger continues with an examination of alternative monetary variables in the consolidated accounts of the banking system. He concludes that, in view of the unhealthy precedents with inflationary finance, it is an illusion to think that citizens can get substantial benefits from the government without having to bear the cost. Governments should therefore rely as little as possible on deficit financing.

Emil-Maria Claassen, Professor of Economics at the Paris-Dauphine University and currently of the UN Economic and Social Commission for Asia and the Pacific in Bangkok, analyzes the experiences of several Asian countries in transition. Contrasting the differences between Russia and China, he argues that China, with a per capita income one-fifth that of Russia, is still a developing country with a large source of surplus labor to draw on in the agricultural sector. China and the Indochinese countries have been showcases of great success, while Eastern Europe and the former Soviet Union appear to have been much less successful. Central Asia represents total failure. One reason for this failure lies in the fact that the successful countries also belong to the group of “classical” developing countries with a large part of their labor force located in the rural sector. Toward the end of the 1980s, the share of agriculture in total employment was 72.3 percent in Vietnam. China’s relative share of agricultural employment was 70.8 percent in 1978 and it declined to 58.6 percent in 1992. The Russian and Eastern European experience was quite different: the employment share of agriculture was 13.1 percent in Russia and 27.8 percent in Poland. Central Asia’s reservoir of agricultural labor to draw upon is somewhat higher on the average but still much lower than China’s, with 23 percent in Kazakstan, 34 percent in the Kyrgyz Republic, 38 percent in Uzbekistan, 41 percent in Turkmenistan, and 42 percent in Tajikistan. Decollectivization and price adjustment for agricultural products provoked an output boom in Vietnam and China, which led to labor migration from agricultural toward new activities that caused the expansion in industrial production.

A major remaining problem for the transition countries is that of state-owned industry as the main cause of budget deficits, inflation, and monetary instability. Those countries that have high inflation must implement a disciplined monetary-fiscal policy mix. Inflation cannot be stopped without control over the supply of money, and control over the supply of money cannot be achieved if the central bank has to finance large public sector deficits. Monetary stability, Claassen concludes, is a precondition for exchange rate stability.

Muthi Samudram, of the Malaysian Institute of Economic Research, analyzes the process of growth and inflation in Malaysia. The Malaysian economy grew at an average rate of about 7–8 percent between 1986 and 1995. Concomitant with that growth were a rise in wages and accelerating inflationary pressures. Inflation was rising well above 4 percent with wages moving in tandem. To combat the threat of inflationary pressures, the Government has taken a number of steps, including restraining credit and lowering import duties.

As a result of rapid growth, the level of unemployment fell from about 8.5 percent in 1986 to 2.4 percent in 1994. This decline in the unemployment rates was, of course, a consequence of employment rising by more than the labor force: during 1988–94, the labor force grew by 1.9 percent a year while employment increased by 3.8 percent. The tight labor market conditions coupled with a high capacity utilization put upward pressure on wages and prices. Inflation increased from 0.7 percent in 1986 to 4.7 percent in 1992 but began to slow down to 4 percent in 1994. Wages, in contrast, rose from 0.8 percent in 1987 to almost 10 percent in 1994.

At this juncture, the concern in the economy is maintenance of price stability with continued growth but without undue pressures on wages. In this respect it is necessary to assess the extent to which the economy is growing above potential output. Potential output growth of the economy is determined by the long-term trend in capital accumulation, productivity, and potential employment. If the findings are such that real output far exceeds the potential growth of the economy, then pressures on inflation can be expected to rise.

During 1980–84, the economy grew well above the potential output growth path, resulting in a positive output gap. During the recession years of 1985–86, actual real GDP was far below potential output. Beginning in 1988, actual real GDP growth accelerated and the output gap began a widening that continued until 1994. The existence of an output gap suggests overheating of the economy, which then leads to the generation of inflationary expectations.

Samudram’s estimate is that the nonaccelerating wage rate of unemployment (NAWRU) was 5.7 percent for 1988–94. This indicates that, in the last six years, actual unemployment has fallen below the NAWRU. The manufacturing average wage rose by 4.1 percent in 1989 and reached 9 percent in 1992.

His analysis also shows that, in recent years, the potential output growth of the economy has been 7–8 percent. With increasing labor shortages, a further increase in potential output growth would require additional capital formation and larger improvements in productivity.

Robert Mundell, Professor of Economics at Columbia University, discusses inflation and growth in the transition economies. Using data on GDP growth for 21 transition countries, he shows that the depth of the contractions in Eastern Europe and the former Soviet Union was on a scale entirely unprecedented and unpredicted. The contractions, which can be attributed in part to the collapse of trade in the former Council for Mutual Economic Assistance and in part to delays in removing the shackles from the private sector, arose because the drop in government output was larger than the increase in private output. The experiences of these countries point out lessons about transition strategies that China should avoid.

The output contractions were accompanied by monetary instability and rampant inflation, which, in a few cases, registered in the four digits. It was generally true that the countries with high inflation rates also had high contractions of output. But it would be a mistake to conclude that the high inflation caused the contractions. Without denying the feedback effects, it would be more accurate to conclude that high contractions, by reducing government revenues, created budget deficits that, through inflationary finance, caused the inflations. In turn, the monetary and fiscal chaos, initially an act of desperation, had feedback effects that exacerbated the contractions and delayed the recovery.

Sustainable Growth and Structural Reform in China

Part II of the book includes papers that deal with long-run issues related to inflation and growth in China. They include the following papers: Hirofumi Uzawa, “Possibility of Sustainable Growth: China and Japan”; Yu-Yun Wang, “Sustainable Economic Development”; D. Gale Johnson, “Is Agriculture a Threat to China’s Growth?”; Yiping Huang, “China’s Agricultural Policy Choices”; Harrison Cheng, “Promoting Township and Village Enterprises as a Growth Strategy in China”; and Ligang Song, “Institutional Change, Trade Composition, and Export Supply Potential in China.”

Hirofumi Uzawa, Professor Emeritus of the University of Tokyo and Research Fellow at the Research Center for Global Warming at RISC in Tokyo, takes a long-run view of the growth process and develops a theory of the sustainability of growth with special reference to China and Japan. For Uzawa, processes of economic development are broadly termed sustainable when two conditions are met: (1) the allocation of scarce resources, including privately appropriated resources as well as those that are publicly or socially managed, is intertemporally efficient; and (2) concurrently, there exists an inherent propensity for the distribution of real income among individual members of the society to become equalized.

Achievement of sustainable development, Uzawa goes on, requires the development of appropriate institutional arrangements and careful attention to social overhead capital. The latter can be classified into three categories: the natural environment—forests, rivers, lakes, soil, atmosphere, and so on; social infrastructure—transport, water, sanitation, power, telecommunications, and irrigation; and institutional capital—medical and educational institutions, judicial and police systems, public administrative services, and financial and monetary institutions.

In China, Uzawa argues, all scarce resources were regarded as social overhead capital and allocated by the state under successive five-year plans up to the late 1970s; social institutions were not endogenously formed but determined by the state. This period was characterized by an inefficient allocation of resources, but overall performance was nevertheless “satisfactory” from both efficiency and equity points of view. In the late 1970s, decentralized processes and incentive mechanisms were introduced, resulting in a far more efficient allocation of resources but accompanied by great instability in the distributive processes and a lack of attention to the environmental consequences of economic development.

In Japan, postwar economic development has been characterized by excellent performance, but exhibits a large number of serious deficiencies from social, cultural, and environmental points of view, creating social instability and a cultural vacuum with grave consequences for the future of Japanese society. The vast sectors of social overhead capital are exclusively managed by the state bureaucracy, not in accordance with its fiduciary responsibilities, but with the sole view of expanding the territorial sphere of influence of each ministerial division.

Both China and Japan share in the dominant role played by the state bureaucracy, which is not particularly favorable to the actualization of sustainable processes of economic development. By the same token, in both China and Japan, professional discipline and individual integrity are not particularly notable in crucial sectors of social overhead capital, such as education and medical institutions, judicial systems, and monetary and financial institutions in particular.

Uzawa concludes that in order to attain sustainable development, it will be necessary to restructure crucial sectors of overhead capital so that professional disciplines are strictly monitored and individual integrity is highly honored. At the same time, every attempt will have to be made to delegate the power and authority appropriate to the institutions in charge of social overhead capital.

Yu-Yun Wang, Chairman of the Department of Mathematical Economics at the Institute of Systems Science of the Academia Sinica in Beijing, also discusses the problem of sustainability but from a different perspective from that of Uzawa. He argues that, while the classical economists of the nineteenth century paid considerable attention to the problem of sustainability, particularly with respect to arable land, the economists of the twentieth century have all but completely ignored the problem. One could read the extensive literature on economic growth, he says, without ever realizing that natural resources and sustainability might be a determinant of growth potential. The literature may reflect the fact that for the first two-thirds of the twentieth century, resource, environment, and ecology constraints were not as serious as they are today for most industrialized countries or for large developing countries like China. A correct analysis requires that the problem of economic development be analyzed in the context of a comprehensive general equilibrium model that takes full account of natural resources and addresses the issue of sustainability, with environment and ecology considerations treated as endogenous to the growth process.

Developing countries, owing to population pressures, had to make every effort for economic advance in spite of the environmental and ecological problems that emerged during the period of economic development. Most of these countries paid little attention to the problem of sustainability. China itself has had bitter experience in this respect. In 1960, after the “Great Leap Forward,” the Chinese Government felt heavy pressure to supply its population with food and grain. Agricultural production was emphasized and was considered to be the foundation of the economy. A lot of money was invested in the key water control project, in the area of the Yellow River Basin, which was intended to combine irrigation with flood prevention. But owing to malfunctioning of the water project and poor management, serious ecological problems of salinization and alkalization of soil were caused—without ameliorating the disasters of the drought-flood cycle.

Wang analyzes the huge Yellow River project initiated in 1982, in the context of an agricultural general equilibrium model, concluding his paper with a description of the model’s mathematical properties.

D. Gale Johnson, Professor Emeritus of the University of Chicago, asks the question: Is agriculture a threat to China’s growth? His quick answer is that it is not, but he hastens to add that, if rapid growth is mismanaged, it becomes a major threat both to the welfare of farm people and agriculture’s contribution to the economy and to overall growth as well. Mismanagement of rapid growth can occur if credit is overextended and if the resulting expansion of the money supply leads to rates of inflation that are politically and socially unacceptable in China.

In the past, China’s record on agriculture—or more exactly the record of the rural people in China—has been remarkable. Since 1978, the more than 200 million rural households have not only increased the output of food at a rate several times the population growth rate, but the quality and variety of the food supply have increased to a remarkable degree. Despite the fact that government investment in agriculture and rural areas has declined significantly during the reform period (both in real terms and as a percentage of total government investment), agricultural GDP grew at 6.1 percent a year from 1979 to 1986 and at 5.3 percent from 1979 to 1993. These are very high rates of growth by international standards. The increase in the per capita caloric supply in China during the period of reform is quite remarkable—an increase of 30 percent to more than 2,600 calories in the late 1980s. For the first time in its recorded history, China has a supply sufficient to provide enough food for a productive life for everyone. It is not claimed that this has been achieved but that the capacity is available to make it possible.

Despite this record of achievement, the level of per capita incomes of rural families has remained significantly below per capita urban incomes for the past decade, as was true for earlier decades. This has been especially true since the widening of the adverse differential in 1988, not by a little but by a lot. In 1993, urban per capita incomes were 2.8 times rural per capita incomes; given the numerous subsidies received by urban families (including housing, medical care, and schooling), the actual income ratio is in excess of 3. And the income ratio widened even further in 1994, with real per capita urban incomes increasing by nearly 9 percent compared with 5 percent for rural per capita incomes.

The spectacular growth of township and village and private enterprises in the rural areas now challenges the highly subsidized and inefficient state manufacturing sector for output supremacy. The people in rural areas created approximately 80 million new nonagricultural jobs from 1983 to 1993, while employment in state enterprises has increased by only 21.5 million in spite of the much greater increase in the capital stock of the state enterprises, both in total and per worker, over the relevant period. Since 1978, rural China, not urban China, has been the engine of growth for the country. This outcome may well be unique in the history of the world.

Johnson concludes that there is a need for a new policy framework for agriculture and rural China. Given rural China’s large contributions to China’s rapid transformation, the countryside should no longer be treated as the home of second- or third-class citizens. There should be active and realistic consideration of what changes will be necessary to reduce the enormous divide between the income and consumption levels of urban and rural households. Achieving this reduction will contribute significantly to the future economic growth of China.

Yiping Huang, of the Research School of Pacific and Asian Studies at Australian National University, discusses China’s policy options in agriculture. He points out that economic reform in China started with adjustments in agricultural policies in 1979. Rapid growth of agricultural output in the first half of the 1980s—regarded as an economic miracle—was produced through agricultural policy reform, mainly through gradually increasing state prices for agricultural products, and implementation of the household responsibility system. Since the mid-1980s, however, the situation has changed, and agricultural policy has frequently been criticized on account of the sluggish growth of agricultural output and the sharp increase in domestic agricultural prices.

The success of the early period, particularly in achieving the “temporary nationwide grain surplus,” can be attributed in part to the narrow range of agricultural alternatives. However, after the implementation of the household responsibility system, farmers dramatically reallocated their resources to non-grain and nonagricultural activities to increase their income. This trend was encouraged and facilitated by new reform policies in other areas of the economy, such as preferential polices adopted to promote the development of township, village, and private enterprises.

After 1985, some general trends can be observed in the midst of the significant fluctuations. Increasing amounts of resources were reallocated away from agricultural production, especially grain production, in the process of economic development. Moreover, domestic prices of some of the most important agricultural products converged quickly with international prices in 1994. This most recent price increase generated high pressure on already high inflation and caused significant difficulties for grain sustainability.

China has three basic agricultural policy alternatives. One is to follow the examples of many countries entering higher stages of development, including, in particular, Japan, Korea, and Taiwan Province of China, and protect the agricultural sector. Such a policy is always well grounded in political considerations, and, furthermore, demand for protection of agriculture can be supported by the food security argument. Against this policy, however, are the arguments that such a policy would further push up food prices and that the examples of Japan, Korea, and Taiwan Province of China indicate that, far from agricultural policy being a blessing to those countries, it has become a very heavy burden to their governments.

A second alternative, which avoids these negative consequences, is to push forward with trade liberalization. By integrating itself with the world economy, China is better able to exercise its comparative advantage and maximize economic welfare. But, against this policy, other economists worry that free trade will increase the instability of domestic food markets. Can China earn enough foreign exchange for grain imports? Will there be a secure supply of grain imports even when there are political conflicts?

A third option in some ways overlaps the other two. The basic idea is to increase domestic supply up to its limit and utilize the international market as a measure to balance domestic demand and supply. China still has great potential to increase further its agricultural yield. Arable land areas are underreported, and reported yields overstated. Productivity can be increased significantly through appropriately reordering agricultural research. The decline in agricultural productivity in the past decade was exaggerated by the fact that government investment in agricultural infrastructure was declining proportionately.

The question is, can China achieve basic self-sufficiency in grain efficiently? Technically speaking, of course, China can achieve self-sufficiency in grain at any time if it is willing to incur the cost. But self-sufficiency is unlikely to be cost effective in the long run.

Harrison Cheng, Professor of Economics at the University of Southern California, discusses the characteristics of the township and village enterprise (TVE) sector, the factors affecting its productivity, and ways in which it could be harnessed in China’s growth strategy. This part of the rural sector that produces light industrial products has emerged as one of the fastest-growing components of the Chinese economy.

Cheng makes a preliminary attempt to evaluate the effectiveness of management on the basis of the total output value for each employee of a rural enterprise, taking into account the effect of complementary factors on this value. His results show, for a sample that includes hundreds of enterprises, the following important factors determining total output value per employee: (1) total fixed assets utilized per employee; (2) variable inputs per employee; (3) percentage of skilled labor force in an enterprise; (4) fraction of bonus payment in the total wage bill; and (5) retained profit of an enterprise at the enterprise director’s disposal. The last two factors suggest the importance of incentives both to workers and to enterprise directors.

Cheng also reviews key aspects of the development of the collective rural economy up to the emergence of the household responsibility system in 1977–78 and the synergetic relationship between the latter and the TVE economy. The TVE sector provides an outlet and a source of income for surplus labor on the farms that helps to sustain rural income. By opening up an alternative to the farm sector and increasing its bargaining power, the TVE sector inhibits the states from retracting reform policies and encroaching on farm rights; land contracts, for example, have been changed from short-term to long-term management.

However, a number of disadvantages are created as a result of the collective ownership of the TVEs. They include the short-term appointment of township officials, which leads to undue focus on short-term objectives; the complete authority of local officials in taxing TVEs; the small pool of local managers; elements of protectionism at the local level; official influence over the credit policies of local banks; and the soft budget constraints for the TVEs owing to their access to credit from public authorities. These factors contribute to the finding that the TVEs are not as well managed as the other private or quasi-private enterprises.

Ligang Song, of the Research School of Pacific and Asian Studies at Australian National University, argues that two fundamental factors, institutional change and trade liberalization, have a strong impact on China’s pattern of trade and therefore on China’s rapid integration with the world economy. At the same time, the combination of the two makes China’s case uniquely different from that of other developing countries undergoing trade liberalization.

Song makes a number of arguments. First, the rapidly changing composition of trade in China during the past 15 years is the result of a convergence of its trade pattern toward market-determined comparative advantage. Such convergence is primarily due to institutional reform, particularly trading system reform designed to introduce the market mechanism into economic and trading activities. Second, China’s export supply potential will be very much determined by progress in further trade liberalization. This leads to a dynamic change of its comparative advantage and may be examined in the context of the contribution of exports to economic growth in China and its integration with the world economy, thus changing the scale of China’s expected future trade expansion and its stature in world trade.

He concludes that the changing pattern of resource endowments in China indicates that China’s commodity composition in foreign trade is evolving in response to changes in factor endowments, particularly capital and skilled labor. This constitutes one important determinant for its export supply potential, namely, a huge potential in exporting not only labor-intensive but also capital-intensive and even more advanced manufactured products to the world market. Such export supply potential will be affected by constraints in the world market. The challenge is that, because of the size of the economy and the increasing scale of foreign trade, both China and other countries have to cope with China’s dynamic realization of its comparative advantage.

Monetary and Exchange Rate Policies in China

Part III deals with specific issues of monetary and exchange rate policies in China. It includes the following papers: Justin Lin, “Inflation and Growth in China’s Transition”; Gang Fan, Wen Hai, and Wing T. Woo, “Decentralized Socialism and Macroeconomic Stability: Lessons from China in the 1980s”; Wenkai Yang, “Significance of China’s New Monetary Law”; Nanping Lu, “Reform of China’s Foreign Exchange System in 1994”; Peigan Gan, “Views on Curbing the Current Round of Inflation in China”; and Bijan Aghevli, “Controlling Inflation: A Principal Policy Challenge for China.”

Justin Lin, Director of the China Center for Economic Research, analyzes China’s economic development, compares its “transition” with that of Eastern Europe and the former Soviet Union, and discusses macroeconomic developments in China’s recent experience. He describes the conditions under which China embarked on its heavy-industry strategy in the 1950s and its need to commandeer the surplus of the economy, which, until then, had been widely distributed; the decision to nationalize private firms must be seen in that perspective. Nevertheless, this strategy was not appropriate to China’s circumstances and therefore led to many of the subsequent problems the economy faced.

Lin discusses the impact of the replacement of collective farming by the household-based system. That transition had already begun when a number of collectives, surreptitiously at first, tried out a system of leasing land and then dividing the obligatory procurement quotas among individual households in the collective. When these collectives brought out yields far larger than those of other teams, the central authorities recognized the existence of this new form of farming but required that it be restricted to poor regions. The latter restriction, however, was largely ignored, and full official acceptance of what came to be called the “household responsibility system” was given in late 1981. By 1983, 98 percent of agricultural collectives in China had adopted the new system.

Reform in the state enterprise sector was achieved in four stages. The first (1979–83) increased enterprise autonomy and expanded the role of financial incentives within the traditional structure, including provision for the retention of profits. In the second stage (1984–86), emphasis shifted toward the formalization of the financial obligations of the state enterprises to the Government, enterprises were exposed to market influences, profit remittances were replaced by a profits tax, and the Government allowed enterprises to sell output in excess of quotas at negotiated prices. In the third stage (1987–92), the contract responsibility system, clarifying the authority and responsibilities of enterprise managers, was adopted. In the fourth stage, since 1993, corporatization has developed as the Government has attempted to introduce the modern corporate system into state enterprises. At each stage, the state enterprises have gained more autonomy.

In macroeconomic policy, the practice of keeping interest rates below equilibrium persists; demand for credit therefore exceeds supply. Whenever credit policy is relaxed, there is a rush to borrow and invest, leading to a growth boom, rapid monetary expansion, and, subsequently, inflation. Because the Government has been reluctant to increase the interest rate, it has resorted to credit rationing and direct investment controls; this tightening, however, invariably favors the less productive state sector, and, while inflation is reduced, growth drops. But because of the soft budget constraint of enterprises, the fiscal income of the Government increasingly depends on the expansion of nonstate sectors, which slows when their access to credit is denied. Because such a slowdown becomes fiscally unacceptable, the state is forced to liberalize and accept faster growth, which then re-creates the inflation problem. Lin argues that the cyclical pattern of growth and inflation has occurred three times since 1984.

Gang Fan (Director of the National Economic Research Institute of the China Reform Foundation), Wen Hai (Assistant Professor of Economics at Fort Lewis College in Durango, Colorado), and Wing T. Woo (Professor of Economics at the University of California at Davis) study the relationship between decentralization, growth, and inflation. From a survey of 300 state-owned enterprises (SOEs), they suggest that both growth and inflation have increased as a result of the decentralization reforms in the state sector. These reforms took the form of gradually increasing over time the operational autonomy of the SOEs: the right to retain a part of profits and disburse it in the form of bonuses; the right to sell a smaller proportion of their output to the state at a fixed price; the right to decide the composition of production; the right to set the prices of new products; and the right to raise their own funds and invest them as they see fit. These reforms have, however, allowed the SOEs to over-consume beyond their means and overinvest beyond prudent levels.

Overconsumption occurs because the managers now have the financial autonomy to accommodate workers’ demands for higher compensation. Over-compensation occurs through direct and indirect increases in income. The authors’ sample showed that the direct income of workers increased 117 percent during 1984–88, while net output increased only 59 percent. Increases in the indirect income of workers took the form of greater collective consumption, more distribution for consumer goods, and better housing. The result of the overconsumption is a secular decline in the profitability of SOEs, which in turn increases the Government’s budget deficit, which is ultimately financed by an increase in the money supply. Higher inflation is the result of this monetization of overconsumption.

Overinvestment by an SOE occurs because the best way to increase the future consumption of its employees is to increase the SOE’s future output. The SOE manager’s proclivity to overinvest is boosted by the knowledge that profits from investment can be privatized to SOE employees through disguised cost increases, while losses from investment will be socialized to the state budget. This explains the authors’ finding that investment decisions of SOEs are insensitive to increases in the interest rate. Also, the SOE manager’s ability to obtain investment funds has been tremendously increased by the decentralization of policymaking authority to state-owned banks (SOBs). The local government, keen to expedite local development, has often pressured the SOBs to accommodate the local demand for loans. The SOBs have been willing accomplices because they have the same incentives as SOEs: profits are privatized and losses are socialized. The result of this confluence of heavy demand for investment funds by SOEs and the ready supply of investment funds by the SOBs is large increases in the money supply to finance fixed-asset investment. The large increase in capital accumulation raises economic growth, while the big expansion in credit raises inflation.

The high inflation caused by the overconsumption and overinvestment of the SOEs may be acceptable if the decentralization reforms have increased the production efficiency of the SOEs. But the sample described in this paper shows that the production efficiency of SOEs has not improved. A review of the empirical literature shows that some studies have found improvements in production efficiency because of implausible deflation methods (that produce declining deflators for value added even though consumer prices have been rising throughout the period). The chief lesson from this paper is that the SOEs must be restructured in market-oriented directions if macroeconomic instability is to be reduced and production efficiency enhanced.

Wenkai Yang, Deputy Director of the Regulation and Law Department of the People’s Bank of China, discusses China’s historic central bank legislation, approved and adopted on March 18, 1995. The law, which drew on wide international experience and suggestions of the IMF and which stimulated much debate inside China, is the first financial law since the founding of the People’s Republic of China 46 years ago. It is designed to establish the People’s Bank of China as the sole monetary authority.

The law establishes the objectives that the central bank is to pursue. But no subject aroused more debate than the precise wording of the specification of the objective. Most agreed that stability of the currency was a primary objective, but should it be the sole objective?

The law has provided a keynote establishing the aim of monetary policy. As to how to implement it, how to coordinate the relationship, and how to control the macroeconomy, there are still great challenges. Tackling these challenges will be the arduous task of the People’s Bank of China in the years ahead.

Nanping Lu, Director of the Policy and Regulation Department of the State Administration of Exchange Control, reviews the great strides China has made toward reforming its foreign exchange system since opening its doors in 1979. Initially, a dual exchange rate system of both official (swap) rate and the market rate was formed; on January 1, 1994, the fixed exchange rate was replaced with a managed floating rate, and the official rate began to be determined by the supply of and demand for foreign exchange in the market, thus putting an end to the dual system. Until then, enterprises had been required to surrender part of their foreign exchange earnings at the official exchange rate but could keep the rest, called foreign exchange quotas, for their own use. The use of the retained quotas had to be approved by different agencies.

The second major reform was the decision, also as of January 1, 1994, that enterprises would sell all their foreign exchange earnings to designated foreign exchange banks, thereby abolishing the retention of foreign exchange quotas and the approval mechanism for the use of foreign exchange under the current account. As a result, conditional convertibility under the current account has been achieved. When enterprises need foreign exchange, they can buy directly from the banks with renminbi and a valid certificate.

In addition, China has strengthened the management of its foreign debt and investment, abolished foreign current settlement for domestic transactions, terminated the issuance and circulation of foreign exchange certificates, improved the statistical and monitoring mechanism for international balance of payments, and consequently established a better foreign exchange system.

The smooth operation of the new foreign exchange system in the past year has shown that the objective of the foreign exchange reform has been realized. Market supply is sufficient and state reserves have increased dramatically. Twenty-two cities have been connected to the interbank market network, and 303 financial institutions have become members of the China Foreign Exchange Trading System.

Reform of the foreign exchange system has helped the economy develop in a fast, healthy, and sustained way. The stable exchange rate restores confidence in the renminbi, which helps to counter inflation and encourage exports. Reform of the foreign exchange system has promoted integration of the Chinese economy with the world economy. Currently, there are almost no restrictions on foreign exchange payments under the current account, and China is therefore very close to meeting the obligations set forth in Article VIII of the IMF’s Articles of Agreement. China will complete the transition from Article XIV to Article VIII status before the year 2000 by realizing convertibility of the Chinese yuan under the current account. To succeed, China must build on the current reforms, including relaxing restrictions on the use of foreign exchange for services, and must further develop its foreign exchange market and consolidate the exchange rate mechanism for its currency.

Peigan Gan, former Director of the Graduate School of the People’s Bank of China, specifically addresses the problem of curbing the current round of inflation in China. Over the past 16 years, he says, China has experienced four rounds of relatively serious inflation. The current round of inflation, which began in July 1994, was associated with the rise in the prices of food products. In 1994, the 12-month retail price index increased by 21.7 percent, the largest increase of the past 16 years. Control of inflation and stabilization of market prices have become China’s highest priorities.

For the purpose of curbing inflation more effectively, it is necessary to explore, and reach a consensus on, the causes of the current round of inflation. First, in Gan’s view, inflation, in the final analysis, is a purely monetary phenomenon.

It is generally believed that the present round of inflation is caused by excessive investment in fixed assets, a rapid increase in consumption, and an excess expansion of money and credit. The money supply (Ml) in China has grown at abnormally high rates in the past four years, ranging between 25 percent and 32 percent. From this fact, a consensus can be reached that the current round of inflation in China is mainly caused by the abnormal growth of M1 during several consecutive recent years.

Second, the fiscal deficit, and the PBC’s overdraft to finance it, was not the cause of the excess supply of money. Rather, this role was shifted to the other state banks. The excessive supply of money was caused mainly by PBC lending to other banks. From 1986 to 1992, PBC lending was 24.1–29.7 percent of GDP. Strengthening the independence of the PBC—to which the new monetary law will contribute—and establishing price stability as the chief objective of monetary policy have become critical for maintaining macroeconomic stability.

A third problem is to deal with the large amount of renminbi created as a result of foreign exchange operations. The sharp increase in reserves strengthened China’s capacity for external payments. But as a result of the purchase of foreign exchange, the PBC supplied an extra Y 284.3 billion, contributing to last year’s increase in the money supply and constituting another main cause of inflation.

A fourth problem is to deal with the eroding quality of bank loans. According to one estimate, overdue and nonperforming loans amount to more than Y 500 billion, or 20 percent of total loans, and it is forecast that a proportion of these 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. 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 could become another new inflationary factor that requires preventive measures.

Bijan Aghevli, Deputy Director of the Central Asia Department at the IMF, discusses growth, inflation, and structural reform in China. He points out that China’s remarkably rapid growth has been accompanied by high and variable inflation. In particular, there have been recurring episodes of macroeconomic instability, with sharp accelerations of inflation during periods of cyclical overheating. The increase in inflation to nearly 22 percent in 1994 is the latest in these periodic inflationary episodes.

Taking a somewhat longer perspective, the paper finds that the average inflation rate over the last 12 years has been quite moderate (about 8 percent), despite a fast pace of monetary growth that has gone to finance a high public sector deficit. The secular decline in velocity observed during this period is associated with the ongoing financial deepening and monetization of the economy. Looking ahead, however, the paper cautions that, in view of a likely slowing in this trend decline in velocity, continuation of rapid monetary expansion carries a greater risk of inflationary pressure.

Against this background, Aghevli reviews the main policy options to sustain growth while bringing about an enduring reduction in inflation. To this end, the paper calls for a significant reduction in the underlying fiscal deficit and a reduction in the expansion of liquidity to quell demand pressures. The recommended measures are broadly in line with the policy framework identified by the Chinese authorities.

Joint ventures accounted for almost 40 percent of foreign trade in 1995 (China Daily, Vol. 15, No. 4516 (January 13, 1996)).

A major priority of the Chinese Government is said to be to maintain ownership of the firms in the “vital” industries, such as telecommunications, steel, electric utilities, and transportation. Firms in these industries number fewer than 1,000, of a total of 74,066 firms (1992), so the scope for privatization is enormous.

Firm indebtedness and the debt-chain problem can be broken into (1) intrafirm debts—mainly debts to workers’ pension funds; (2) interfirm debts; and (3) firm-bank debts. An attempt to resolve the debt-chain problem in the early 1990s did not work because firms gave priority to the use of new central bank funds to cancel intrafirm debt (essentially repayment of debts to pension funds) rather than interfirm debt.

See Gang Yi, Money, Banking, and Financial Markets in China (Boulder, Colorado: Westview Press, 1994).

The monthly inflation rate actually reached a peak in October 1994.

Opening Remarks

Yuan Chen

At the opening of the 1995 international conference “China in the World Economy: Growth and Inflation,” I would like, on behalf of the People’s Bank of China, to extend our warm welcome to Professor Robert Mundell and all the participants and to wish the conference a great success.

The conference focuses on growth and inflation, which are the two major issues in the Chinese economy. Therefore, I would like to make some remarks on China’s monetary policy, which is closely linked with the theme of the conference.

China’s Monetary Policy in the Past Few Years

In many countries, particularly in developed countries, monetary policy is an important instrument for government intervention and management of the economy at the macro level. In China, only since the adoption of the economic reform and opening policy—especially since the establishment of the central bank system—has monetary policy been truly and effectively used as an instrument for macroeconomic management. The deepening of reform has brought significant changes to the economic and financial system and has increased the importance of finance and banking in the national economy. The function of monetary policy in macroeconomic management has thus become critical. During 1988–93 especially, monetary policy played a vital and positive role in cooling down the overheated economy and curbing inflation, thus further enhancing its use in the macroeconomic management system as one of the most important instruments for macroeconomic management in China.

In the past ten years, the People’s Bank of China (PBC), as the central bank, has taken bold steps in exploring the use of monetary policy by drawing on the experience of other countries while taking into consideration China’s circumstances. We have gradually introduced a set of monetary policy instruments, including reserve requirements, rediscounts, central bank lending, credit ceilings, interest rate adjustments, and foreign exchange market operations. These policy instruments have been used flexibly according to China’s circumstances, economic conditions, and macroeconomic management targets at different times and have yielded favorable results. The PBC has set up an indicator system with different levels of money supply as the major indicator. Starting from September 1994, statistics for the money supply at different levels have been published quarterly and used by the PBC as an important indicator to monitor monetary policy implementation. We should say that the PBC has now developed the ability to operate monetary policy flexibly and effectively.

The operation of monetary policy varies with changes in economic and financial conditions. In China, the tightening or loosening of monetary policy is basically determined by economic performance and the degree of inflation. In the past few years, especially since the second half of 1993, an appropriately tight monetary policy has been adopted in China because of the overheating of the economy since the second half of 1992; under the circumstances, a lax monetary policy would have further fueled the overheated economy, which would have required an even more restrictive policy later, consequently causing great waste and strong turbulence. Despite the relatively tight monetary policy, money supply growth was still excessive. In 1994, the central bank’s supply of base money, narrow money (Ml), and broad money (Ml) increased by 34.35 percent, 26.8 percent, and 34.4 percent, respectively, over 1993. This rapid increase of the money supply was caused by excessive investment and the rapid accumulation of foreign exchange reserves in 1994, which increased base money and forced M1 and M2 to grow rapidly. This has demonstrated from another perspective that the tight monetary policy adopted in the past few years is necessary. It was the tight monetary policy that cooled the overheated economy and functioned as a brake in these years.

Inflationary Pressures

The Chinese economy has been growing at more than 10 percent a year over the past few years, and the GNP growth rate for 1993 was 13.4 percent and for 1994, 11 percent. In the meantime, inflation has been conspicuous in the past two years, with the consumer retail price index increasing at two-digit rates, at 13.2 percent in 1993 and 21.7 percent in 1994. These conditions indicate that inflation during this period is not a temporary and sudden phenomenon and cannot be corrected easily. We need to deal with the issue objectively and calmly and be prepared to intensify our efforts.

First, it should be recognized that inflation accompanies relatively rapid economic growth in a developing country like China. Economic growth is always an important issue for developing countries. Without fast growth, the essential needs of the people cannot be satisfied, nor can their quality of life be improved. Therefore, economic growth is a tremendous need for the whole nation. In addition, because of China’s relatively backward technology, improvements in economic efficiency are achieved mainly through a higher growth rate, which is what we call a “speed efficiency” economy.

China is a developing country with a large population. The Central Government has firmly indicated that economic growth cannot be promoted at the cost of inflation. Yet, the enthusiasm for economic growth in some localities is so strong that it is very difficult to stop completely excessive investment financed through forced bank credit. This is one of the important factors that have contributed to the excessive increase of the money supply and higher inflation, and it must be wrestled with in our effort to control inflation. On the other hand, weaknesses in the current monetary policy and system of financial supervision leave loopholes that allow inflationary pressures to form. Improvement of the system, however, would be a gradual process and requires consistent efforts. This points to the need for institution building with the goal of transforming the current system into an efficient and strictly supervised system that would function effectively in a market economy.

Next, because China is in transition to a market economy, inflation is created in the following two ways:

1. In the process of transition, various systemic reforms, especially price reforms, are indispensable. The relatively low prices for agricultural and sideline products that prevailed for a long time in the past created the danger of a supply shortage for China’s large population. On the other hand, large-scale fixed investment and the industrialization of the economy have led to a large migration of the rural population to urban areas. Thus, the problem of an insufficient supply of agricultural products may exist in China for some time. The upward adjustment of agricultural prices has been one of the most important reasons for the overall inflation because agricultural prices account for about 55–60 percent of the overall price level. Reforms in other areas have had similar effects on prices. Reforms of the tax and foreign exchange system also contributed to some extent to the price increase in 1994. These price-increasing factors are unavoidable, and the best we can do is minimize their negative effects, eliminate the loopholes in the transition process, and establish the new economic system.

2. In the transition period, the management methods that suited the planned economy are either less effective or ineffective, while new ones are not yet available or not widely mastered, leading to weaknesses in management, especially in solving some of the new problems. This situation has made some people feel at a loss and encouraged others to take advantage of loopholes. In a large country like China, any disorder caused by loopholes in the system or by misguidance may lead to overall unbalance. The real estate boom and irregular fund-raising activities that occurred in 1993 are examples. In the distribution area, irrational price increases also occurred. The disorder that occurred in the distribution system last year was closely linked to the lack of management skills during the reform of this system. It is very difficult to design a perfect new system in the transition period, and the new system can be perfected only by correcting the problems. This process is unavoidable and in itself fuels inflation.

As the country’s monetary authority and the central bank, the PBC is firmly committed to inflation control. Such an effort, however, should be based on an in-depth analysis of inflation so that it can be more focused and more effective. Sustained economic growth cannot be achieved through inflation in developing countries, and inflation itself cannot bring about healthy growth, but, on the contrary, could damage the common interests of all people. The position of the central bank needs to be clearly stated. Inflation would also lead to serious social problems. We at the central bank should do our best to minimize inflation in the process of economic growth, and this is the ultimate objective of central bank monetary policy.

Monetary Policy in 1995 and Beyond

The persistently high inflation in 1994 became a matter of serious concern not only for the central bank, but also for the Chinese Government. The Government acted decisively by introducing ten major measures in September 1994 and put inflation control at the top of its economic agenda for the last quarter of 1994 and for 1995. The PBC, on its part, has called back loans to state specialized banks and required the banks to make special deposits at the PBC, with a view to reducing their credit activities, offsetting and sterilizing the monetary impact of the growth of central bank foreign exchange reserves. In January 1995, the central bank also raised the interest rate on its lending to commercial banks. Together, these measures have brought inflation down in the first quarter of 1995. The 12-month increase in commodity retail prices for March was 18.7 percent, 3 percentage points lower than in December 1994.

For 1995, the central bank will continue to pursue an appropriately tight monetary policy. Such tightening is the basic point of monetary policy. By “appropriate,” it is meant that the tightening is not complete austerity. Given the country’s realities, monetary austerity could cause economic recession and, in particular, have an impact on infrastructure investment and industrial and agricultural production. The impact on these “bottleneck” industries could, in turn, have significantly negative effects on economic growth. For this reason, excessive tightening is considered undesirable. For the past few years, monetary policy has been on the tight side, and, if an appropriately tight policy can be maintained in 1995, basic currency stability is achievable. “Appropriately tight” also implies that for enterprises and projects in need of financial support, especially those in the areas of capital construction, state key projects, and agriculture, bank lending will not be cut off. By contrast, for the overheated segments of industrial production, stockpiling enterprises, and those parts of the real estate sector that have bubbles and are overheated, bank credit will be strictly and firmly controlled. Such a policy stance reflects China’s monetary policy during the transitional period; namely, monetary policy is used not only for adjusting monetary aggregates, but also for economic structural adjustment. Striking an appropriate balance between the two has always been the task of the central bank, with, however, control of monetary aggregates as a prerequisite.

Given the appropriately tight monetary stance, the 1995 credit growth of state banks has been set at 570 billion yuan, cash issuance at 150 billion yuan, M2 growth at 23–25 percent, and inflation at 15 percent. Achieving these targets remains a challenging task for this year. The targets have been set after careful calculation and are therefore broadly in line with the principle of appropriate tightening.

Monetary policy will remain on the tight side for several years beyond 1995. The reason is that it is impossible to completely eliminate, in the several years to come, the factors behind potential inflationary pressure, such as excessively strong investment demand, scarce capital, and transition-related complications. It is thus necessary and mandatory to adopt an appropriately tight monetary policy to stabilize the value of the currency and to provide a sound monetary environment for the growth of the economy. Nonetheless, to ensure an appropriate degree of tightness, timely adjustment to actual conditions is warranted.

To facilitate the implementation of the appropriately tight monetary policy, improvement of monetary policy instruments is required, along with other adjustments. At present, the main monetary policy instruments used by the PBC are interest rates, credit quotas, and central bank lending to specialized banks. The use of these instruments, however, will be gradually reduced, with the money supply breaking into more layers, financial institutions becoming diversified, the financial market being developed, and the specialized banks being transformed into commercial banks. More attention will be paid to the use of indirect monetary policy instruments. The proportion of rediscounting will be increased, and experimentation with open market operations based on government securities is being considered. Preparations for such an experiment have been under way for a year and a half. As a result, the bank is essentially ready to start open market operations at an appropriate time this year.

Preparations have also been made in the area of interest rate reform. In January 1995, the central bank began to adjust only the central bank lending rate in the hope that it would gradually become a benchmark rate and, in turn, influence the behavior and interest rates of commercial banks. This action represents a major reform of the interest rate system. Moreover, the bank is going to introduce reserve money programming gradually in an effort to achieve effective control of the monetary base. The recently promulgated People’s Bank Law provides for the establishment of a monetary policy committee within the PBC, which will no doubt help accelerate the reform of China’s monetary policy system. We are confident that monetary policy implementation will become more effective as reform accelerates in the years to come.

Ladies and gentlemen, the monetary policy objective of the PBC is to stabilize the value of the currency and thereby promote economic growth. This objective is now explicitly specified in the People’s Bank Law and is broadly consistent with international practice; meanwhile, it also reflects China’s realities and unique features. Despite difficulties in achieving this objective, the PBC is, as it has always been, committed to learning by doing, learning from the central banks of developed market economies and from experts in international academic circles. We sincerely hope that this seminar can contribute to the process of an increasing maturity of China’s monetary policy. We are also looking forward to hearing your comments and suggestions on how to make China’s monetary policy more effective.

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