China’s reforms were manifested in impressive output gains, particularly in agriculture, in the nonstate industrial sector and in external trade. On the negative side, the industrial sector has been retarded by the slow pace of reform in the state-owned enterprise sector. Moreover, the relatively gradual pace of reform and the inadequacy of instruments of macroeconomic control have been reflected in the recurring periods of economic instability. This section examines the effect of reforms on selected aspects of the economy. The impact of reforms is first reviewed from the perspective of the level and structure of real economic activity and the extent of China’s integration into the global economy. A review is then conducted of the implications of the reforms, particularly the pronounced decentralization that has taken place, for macroeconomic management and stability. The section ends with a brief outline of the reforms necessary to enable effective market-based macroeconomic management.

China’s reforms were manifested in impressive output gains, particularly in agriculture, in the nonstate industrial sector and in external trade. On the negative side, the industrial sector has been retarded by the slow pace of reform in the state-owned enterprise sector. Moreover, the relatively gradual pace of reform and the inadequacy of instruments of macroeconomic control have been reflected in the recurring periods of economic instability. This section examines the effect of reforms on selected aspects of the economy. The impact of reforms is first reviewed from the perspective of the level and structure of real economic activity and the extent of China’s integration into the global economy. A review is then conducted of the implications of the reforms, particularly the pronounced decentralization that has taken place, for macroeconomic management and stability. The section ends with a brief outline of the reforms necessary to enable effective market-based macroeconomic management.

Impact on Economic Activity


After the inception of the reforms, real growth accelerated markedly. Growth rates of real net material product rose from an average of about 6 percent in the 25 years between 1953 and 1978 to more than 9 percent between 1979 and 1992 (Table 1 and Chart 7). This acceleration was predominantly due to a sharp increase in the growth of total factor productivity, although increases in the growth rate of capital stock also contributed.96 An important goal of the reform effort was to facilitate the import of technology to modernize the economy. The growth in productivity was undoubtedly reinforced by the resultant technological progress.

Chart 7.
Chart 7.

Selected Economic Indicators

Sources: Data provided by the Chinese authorities; and IMF staff estimates.1End of period.

Agricultural Output

The agricultural sector made the most significant contribution to the increase in productivity and output growth in the early years of the reform. Between 1978 and 1984, output grew by an annual average of about 8.8 percent.97 These impressive gains can be attributed both to the introduction of improved individual incentives embodied in the household responsibility system as well as to increases in procurement prices.98 The growth of total agricultural production moderated to an average of about 4 percent from 1985 to 1991, reflecting a number of factors: less improvement in the relative prices of agricultural products (especially grain) than in earlier years; the resumption of the practice of requiring farmers to sell grain to the state at below-market prices; low investment in agriculture and related infrastructure by farmers, who have tended to invest in housing, and by collectives, which may have preferred to invest in TVEs; the outflow of the labor force from the cropping sector; increasing fragmentation of land holdings; and the difficulty of replicating the one-time productivity gains arising from the termination of the commune system.


The period after 1978 also witnessed more rapid growth in industrial output, but closer analysis reveals that the most significant impact came from the nonstate-owned enterprises, including TVEs, individual, and foreign-funded enterprises. The initial impact of the reforms on the state-owned enterprises was to increase the rate of growth of output from an average of 6 percent between 1980 and 1983 to over 10 percent during 1984–88. However, the SOEs did not show the same dynamism as the agricultural and nonstate-owned industrial sectors. Table 15 shows the declining share of state-owned enterprises in the gross value of industrial output from just over 80 percent in 1978 to less than 50 percent in 1992. Between 1989 and 1992, the gross value of output of the SOEs grew by an annual average of 24 percent, while that of nonstate-owned industries grew by nearly 15 percent.

Table 15.

Gross Value of industrial Output by Form of Ownership

(In percent)

Source: China Statistical Yearbook, various issues.

Includes foreign enterprises.

The primary problem is that the objective functions of large and medium-scale state-owned enterprises are not limited to maximizing profits but include a host of other social and economic objectives. State-owned enterprises are not only a major source of employment but also perform social welfare functions, such as providing housing, medical care, and education to their employees. As a result, although there is a bankruptcy law, it has been used only sparingly. The state, for its part, has protected the SOE sector through its pricing policies, the budget, and the banking system. Also, there has been little significant “hardening” of enterprise budget constraints. For the most part, the state-owned industrial sector remains characterized by overstaffed and inefficient enterprises producing goods of substandard quality, incurring losses on account of both distortions caused by pricing policies as well as fundamental inefficiency associated with the lack of competition, undertaking inappropriate investments, and unable to compete with the more dynamic non-state industrial sector.

The opportunities provided by the reforms in the agricultural sector for the development of “sideline” activities in the rural areas laid the foundation for rural enterprises, or township and village enterprises. Conceived as a means of absorbing surplus labor associated with rising agricultural productivity, their dynamic growth was a largely unanticipated phenomenon. It may be attributed to a number of factors, including their concentration on consumer goods that were in high demand, the ready availability of labor, the limited capital requirements, and the freedom from government controls. Moreover, no constraints were imposed by the need to overhaul existing institutions or to renew capital stock as was true for the SOEs. Finally, although the TVEs remained publicly owned (albeit at a lower level of government), they have faced a much harder budget constraint than the SOEs.

Income Distribution

The rapid growth during the first half of the 1980s led to a dramatic reduction in the incidence of poverty, from 28 percent in 1978 to less than 9 percent in 1984.99 The large productivity and output gains in the agricultural sector resulted in a decline in rural poverty from 33 percent in 1978 to about 11 percent in 1984. Since then, however, there has been little progress on this front, despite strong growth in rural output, primarily because the once-and-for-all benefits of agricultural reforms have been reaped, and the TVEs, which are the main source of continued growth in rural areas, have not developed in remote areas, to which poverty is now largely confined. As for the effect of reforms on income inequality, the Gini coefficient for rural households increased slightly between the early 1980s and 1990, indicating an increase in income inequality. Also, data on differential regional growth rates suggest that income disparities may have widened. However, the existence of significant interprovincial budgetary transfers may have ameliorated this development.

Integration into the Global Economy


Before external sector reforms were initiated in 1978, only 12 state foreign trade corporations (FTCs), under the erstwhile Ministry of Foreign Economic Relations and Trade (MOFERT) (now known as the Ministry of Foreign Trade and Economic Cooperation—MOFTEC), were responsible for foreign trade in China. For the country as a whole, levels of exports and imports were set by the central government in the framework of government plans. The use of foreign capital in the form of borrowed resources or foreign direct investment was kept very low by design. To make foreign trade and investment more market oriented, the Government decentralized decision-making powers that affected exports and imports, as well as foreign direct investment. Areas of foreign trade subject to central planning were reduced significantly, and the Government now uses the system of import licensing and import and export duties to influence trade flows.

The Government has also used the exchange rate and the foreign exchange retention system to encourage the production of export goods. Other measures to influence China’s foreign trade flows have included a reduction in the number of export commodities that are subject to quotas and to various export taxes and preferential financing for exports. To liberalize the import regime, China’s tariff system has also been modified in recent years. These modifications have helped the country to reduce significantly the average level of tariff rates applied on the imports of certain goods, in particular capital goods and equipment. As a consequence, tariffs on China’s industrial imports are structured so that they provide more protection to finished goods than to intermediate goods. Intermediate and capital goods are mostly subject to rates of 20–40 percent, while rates on most finished consumer goods are over 60 percent. This policy is to discourage consumption of “nonessential and luxury imports” and to provide high margins of effective protection to domestic industrial production.

China has also created a favorable environment for the use of foreign capital in recent years to accelerate the modernization of its economy. A law promulgated in 1979 defines conditions under which joint ventures can be set up in China. Tax incentives and other preferential policies are offered to foreign investors who are willing to develop projects in designated open economic zones (see Section IV above).

Trends in Foreign Trade and Investment

The policy of opening the economy to the rest of the world has resulted in a marked expansion of foreign trade and investment during the last decade. Exports in constant prices grew at an average rate of 12 percent a year in 1980–91, making China the thirteenth largest exporter in the world in 1991, up from twenty-sixth in 1980. China’s merchandise trade as a ratio of its current price GNP100 increased from 12.8 percent in 1980 to over 38 percent in 1992 (Table 16).

Table 16.

External Sector Indicators

(In billions of U.S. dollars, unless otherwise indicated)

Sources: China Customs Statistics, various issues; China Statistical Yearbook, various issues; and IMF staff estimates.

On a customs basis.

This increase in the relative importance of foreign trade in the Chinese economy reflected, to a large extent, the growing export orientation of the economies of coastal regions. Exports also increased rapidly with the establishment of foreign-funded enterprises. Hong Kong-based enterprises have been taking advantage of China’s cheap labor and land to develop mainly labor-intensive industries in open economic zones. These enterprises have diversified China’s industrial production of export goods. The share of industrial exports in China’s total increased from about 50 percent in 1980 to about 80 percent in 1992. Apart from two consecutive declines in 1984–85, this ratio increased steadily during 1980–91 (Table 17).

Table 17.

Foreign Trade by Major Commodity Groups

(In percent of total)

Sources: China Customs Statistics; and IMF staff estimates.

China’s industrial exports have continued to be heavily concentrated in light industrial goods. Products such as textiles, clothing, telecommunications equipment, and arts and crafts still represent a high percentage of total exports. Changes in the commodity composition of China’s exports measured by the Hirschman concentration index101 do not seem to have been significant during 1980–91. The degree of commodity concentration of China’s exports declined only marginally from 41.4 percent in 1980 to slightly less than 40 percent in 1991 (Table 16).

At the same time, there has also been a relative concentration of China’s foreign trade in a limited number of markets (based on China’s data sources). China’s direct trading partners appear to be the Asian countries that presently account for more than 65 percent of its total exports. Among these countries, Hong Kong plays a leading role. As a broad generalization, imports of intermediate and capital goods come from Asia—notably Hong Kong and Japan—and finished consumer goods are exported mainly to the United States and Europe.

Foreign capital flows have increased rapidly as a result of preferential policies offered by the Chinese Government. These policies have attracted numerous Hong Kong investors, particularly in the form of contractual joint ventures. By the end of 1992, over 80,000 foreign-funded enterprises had been approved in China. About one-third of these enterprises were in tourism and other service sectors, while the other enterprises invested in crude oil exploration and assembly and processing industries. About two-thirds of total foreign investment originated from Hong Kong. However, investment from the United States, Europe, and Japan has also increased rapidly.102

Assessing the Degree of Integration

In assessing the degree of China’s integration into the global economy, one must take into account developments in its trade and investment flows as well as improvements in its productivity and international competitiveness. This is important because increases in China’s exports103 could result from a reduction in domestic absorption of some of its export commodities or an increase in the utilization of previously idle production capacity. In these two cases, China’s exports could increase even when its productivity and international competitiveness have not improved. Such an expansion of exports would be transient because it could end as soon as all existing capacity has been utilized or domestic absorption of exportable goods can no longer be reduced.

Various indicators, including changes in labor productivity and the behavior of China’s real effective exchange rate (Charts 8 and 9), point to productivity increases and inexpensive labor as important factors in the rapid growth of exports. As a result, the country’s share of world trade almost doubled, from 1 percent in 1980 to 1.9 percent in 1991. At the same time, its share of world imports increased from 1 percent in 1980 to 1.8 percent in 1991 (Chart 10). China’s GNP also became more dependent on export production during that period. From 6.1 percent of GNP in 1980, the ratio of China’s exports to GNP rose to 19.3 percent in 1991 (Chart 11).104

Chart 8.
Chart 8.

Labor Productivity in Industrial Sector in Selected Economies

(1985 = 100)

Sources: Data provided by the authorities.
Chart 9.
Chart 9.

Real Effective Exchange Rates in Selected Economies

(1985 = 100)

Source: IMF, Information Notice System.
Chart 10.
Chart 10.

Share of World Trade

(In percent)

Source: Data provided by Chinese authorities.
Chart 11.
Chart 11.

Measures of China’s Openness

(In percent of GNP)

Source: Data provided by Chinese authorities.1The openness of the economy is measured as the ratio of China’s trade to GNP in current prices, using official exchange rate.

The heavy concentration of China’s foreign trade in terms of its commodity composition and trading partner countries suggests that China still has considerable potential to increase its relative weight in world trade. The Hirschman commodity concentration indices for China’s foreign trade during 1980–91 clearly show that there has been a small diversification of the country’s export base. For the same period, the concentration of imports did not change, although the concentration index fell during 1985–91 because of increased operations of foreign-funded enterprises during that period.

In addition to policies to promote exports and attract foreign direct investment in China, the authorities adopted measures to facilitate other financial flows between China and the rest of the world. Enterprises from mainland China began to raise capital on the Hong Kong stock market during the late 1980s, and the amount of bonds issued by Chinese agencies in various external markets increased substantially between 1980 and 1986. Although this amount fell between 1987 and 1991, it began to pick up again in 1992. Reflecting this issuance of bonds and the use of other forms of foreign borrowing, China’s external debt is estimated to have increased rapidly during 1980–92. Public and publicly guaranteed debt increased from $4.5 billion in 1980 to over $58 billion in 1992, of which total outstanding debt borrowed from commercial banks increased from $1.5 billion in 1980 to about $18 billion in 1992. As a result, outstanding external debt as a ratio of exports of goods and nonfactor services increased more than threefold, from 22.4 percent in 1980 to 78.4 percent in 1992. Investments in equity shares are also increasingly taking place between China and the rest of the world. China is actively supporting the sale of special shares to foreigners at the stock exchange markets in Shanghai and Shenzhen.

A further indicator of the increasing significance of China in the global economy is the rise in its share of the international (non-gold) reserves of reporting territories. From less than 1 percent in 1978, China’s reserves increased—notably in the later years of the period—to about 5 percent at end-1991. In absolute terms, its ranking rose from fortieth to seventh during this period.

In conclusion, measured in terms of trade and investment flows, China’s economy has become increasingly integrated into the world economy. One manifestation of this integration is the narrowing of the gap between domestic and international prices of many tradable goods as a result of price reforms. This process will be strengthened by the recent opening of the service sector and the inland provinces to foreign trade and investment and the intention to adopt international conventions and practices in accounting and in the legal and regulatory framework.

Decentralization and Macroeconomic Policy

Section V reviewed center-local relations in the fiscal, financial, and external areas. An examination of the various institutions suggests that, although decision making has been extensively decentralized, many aspects of the planning process are replicated at the provincial level, which has retarded efforts to develop an indirect system of macroeconomic management.

Fiscal Policy

In the fiscal area, the ad hoc nature of the contractual relations between the central and local governments has led to a tendency for overall expenditures to exceed the approved budget. Since local governments are generally not permitted to run deficits,105 Wong (1991) points out that there have been three types of responses to local demand pressures: first, local authorities have attempted to negotiate more favorable fiscal packages with the center; second, they have stepped outside the normal budgetary process by tapping the very large “extrabudgetary funds” of locally owned SOEs; third, they have attempted to expand the local tax base by promoting local economic growth. To these may be added a fourth development that has become increasingly common in the 1990s: the various means of circumventing the prohibition on the issue of bonds or bank borrowing. For instance, in 1992–93, it is reported that many local authorities and SOEs issued various forms of financial instruments.106

These different responses have together imparted an expansionary bias to fiscal policy as they have led to overall expenditures financed directly or indirectly through borrowing. Moreover, the risk of inefficient duplication of investment is heightened as provinces finance their investment with extrabudgetary funds generated from enterprises under their jurisdiction. The significance of the extrabudgetary funds is illustrated in Table 13. The secular decline in the government revenue/GNP ratio was offset by the growth of extrabudgetary funds through the mid-1980s, although subsequently the latter also began to decline. Cross-provincial data for 1990 further illustrate the significance of the extrabudgetary funds when considered together with budgetary resources (Chart 4), although it would appear that the overall level of extrabudgetary operations does not alter the financial balance in most provinces. It must be stressed that the bulk of the resources in the extrabudgetary funds are enterprises’ funds that are not automatically at the disposal of governments but represent an additional revenue base—equivalent to 5–18 percent of GNP across the provinces—that local governments may attempt to tap.

Also, as local governments have been allowed to make direct investments in industry or commerce and have done so to increase local revenues to cover local expenditures, it may be argued that it was the imperative of raising revenue that spurred the growth observed in many provinces. Clearly this has been one way in which signals concerning reforms emanating from the center are quickly translated into growth. It has also been a source of macroeconomic pressure: since local expenditure is not regulated within a coherent overall economic framework, there is a greater risk of overheating, particularly where local governments bring pressure to bear on banks for additional lending or issue bonds without authorization.

Monetary Policy

As with fiscal policy, in credit policy provincial authorities may pursue local objectives that are not consistent with national policies, bringing pressure to bear on the provincial banking system that undermines the center’s monetary policy goals. With the establishment of a two-tiered banking system, various instruments have acquired greater significance in the conduct of monetary policy, including lending to banks by the People’s Bank, reserve requirements, and—to an increasing extent—interest rates. However, the credit plan remains the principal instrument of monetary policy. Although it is formulated at the national level in accordance with macroeconomic targets of real growth and inflation, its implementation is highly decentralized; as a consequence the annual credit ceiling has generally been exceeded.

Until 1988, monitoring and control of the credit plan was relatively lax. In 1989, under the rectification program, it was tightened, with considerable powers being retrieved by the center. The subsequent relaxation of the monetary policy stance has been accompanied by a corresponding relaxation of control over the credit plan. In 1991, limited autonomy was given to the provincial branches to make small variations in the composition of credit expansion under the plan. In 1992 and 1993 there have been growing signs of pressure for greater autonomy in credit allocation. Indeed, against the background of local pressure for investment funds, the banks have extended credit by means outside the normal credit plan.

External Policies

The authorities’ strategy of moving toward a unified market-oriented exchange rate is hampered by local restrictions on the free flow of foreign exchange and the absence of an integrated national market. In this environment, there is no guarantee of uniform conditions for access to the market, since access is determined at the local level by the branches of the SAEC. Furthermore, evidence suggests that the restrictiveness of the trade regime varies widely among provinces and regions in China.

Macroeconomic Management and Stability107


Since 1978, China has experienced periods of macroeconomic instability that have interacted with the implementation of reform, Macroeconomic cycles are not unique to China or to the post-reform period, although their characteristics have been altered by the advent of reform. In the pre-reform period, owing to pervasive price and trade controls, the cycles were manifested in wide swings in the growth of output. In the post-reform period, not unexpectedly, the cyclical episodes have been characterized by fluctuations in the inflation rate and the balance of payments, with less pronounced swings in output growth. Although it is difficult to assess which type of instability imposes higher costs on the economy, the Chinese authorities, perhaps as a consequence of the hyperinflationary experience of the late 1940s, attach great importance to price stability. Their concern that too rapid a pace of reform might exacerbate inflation is heightened by their desire to avoid a repetition of the social turbulence of earlier years.

The macroeconomic cycles have had a number of characteristics in common: an increase in aggregate demand, especially investment demand associated with an acceleration or new phase of reform; the ratification of the increase in aggregate demand through credit expansion, reflecting the tendency by economic agents to equate the acceleration of reforms with a call for higher growth; the emergence of shortages and bottlenecks in critical sectors that led to an acceleration in inflation and/or a deterioration of the balance of payments—"overheating"; and finally, attempts to stabilize the economy primarily through the imposition of administrative controls and a slowdown, or, in some cases, a partial reversal, of the reform process.108

The Cycles

First Cycle: 1979–82

During this first cycle, agricultural reform was initiated, and profit retention by enterprises replaced profit transfers to the state. The resultant increase in rural incomes, as well as the worsening of the overall fiscal balance (the latter owing both to a decline in revenues and to a sharp increase in subsidies as higher agricultural procurement prices were not passed on to consumers), led to a surge in aggregate demand. At the same time, domestic investment growth also rose sharply (Table 18). Credit expanded rapidly to accommodate the demand growth; the seasonally adjusted annualized quarterly growth rate rose from 12.5 percent in mid-1979 to 25 percent by the end of 1979 and remained high throughout 1980 (Table 19 and Chart 12). Inflation accelerated to nearly 20 percent on an annualized basis in the fourth quarter of 1979 and the trade balance deteriorated sharply. The authorities responded by tightening some price controls in 1980, direct credit controls and trade policies during 1981, and slashing the state’s investment budget. Inflation fell, output growth moderated, and, with a short lag, import growth was compressed and the trade balance swung into surplus by the third quarter of 1981.

Table 18.

Selected Macroeconomic Indicators

(Annual percent change, unless otherwise specified)

Sources: China Statistical Yearbook, 1992; and data provided by the Chinese authorities.

In U.S. dollar terms.

Table 19.

Key Macroeconomic Indicators

(Seasonally adjusted annualized quarterly rates, unless otherwise indicated)

Sources: IMF, International Financial Statistics, various issues; and data provided by the Chinese authorities.

In U.S. dollar terms.

In billions of U.S. dollars.

Chart 12.
Chart 12.

Key Macroeconomic Indicators1

Sources: Data provided by the Chinese authorities; and IMF staff estimates.1The first cycle covers 1979–82, for which limited quarterly data are available.2Seasonally adjusted annualized quarterly growth rate.

Second Cycle: 1984–Early 1986

Beginning in 1984, the two-tier pricing system was introduced, enterprises were granted greater autonomy in setting wages, a two-tier banking system was established, and a phased liberalization of the foreign trade regime was initiated. Again, aggregate demand grew sharply as enterprises, subject to their customary soft budget constraints, granted large increases in wages and increased their investment spending. At the same time, the People’s Bank of China had not been vested with the operational or institutional instruments necessary to control credit expansion effectively in the new, more decentralized banking system. Credit expansion rose from an annualized rate of 9 percent in the first quarter to 76 percent by the fourth quarter of 1984. The decentralization of foreign trade decisions led to a spillover of excess demand into the balance of payments. By mid-1985, inflation and import growth had accelerated sharply. Once again, the authorities responded by tightening credit, foreign trade, and exchange controls. In addition, interest rates were increased and the renminbi devalued.

Third Cycle: Mid-1986–Late 1988

In this period the contract responsibility system for enterprises was introduced, restrictions on the operations of specialized banks were lowered, and universal banks and the first FEACs were established. Largely reflecting a sharp deterioration in the overall budgetary balance, aggregate demand growth accelerated. The increases in several administered prices in early 1988 were implemented in an already overheated economy and exacerbated existing inflationary expectations; the quarterly inflation rate soared from an annual rate of 14 percent in the first quarter of 1988 to 21 percent in the second quarter and reached an alarming 43 percent in the third quarter. The authorities’ response was a system-wide retrenchment that began in late 1988—the rectification program—under which administrative controls on imports and credit were tightened, some price controls were recentralized, and state investment expenditure was slashed. During 1989, interest rates were increased, and the renminbi was devalued by 21 percent. Inflation and the growth rates of industrial production and imports slowed, and the external balance turned sharply into surplus.

The most recent retrenchment was particularly pronounced because it was associated with renewed debate within the leadership about China’s reform process. Fundamental questions were raised, including considerations of ownership and even broader political issues. Following a hiatus of almost three years, the pace of reform began to regain momentum during 1991.

Fourth Cycle: Late 1991–Present

A new phase in the process of opening and reforming the Chinese economy began in 1992. The process of opening the economy was extended, which had previously been largely confined to specific enclaves in coastal areas and other special economic zones, to encompass several inland and border areas, and far-reaching price reforms were implemented. Prices of commodities that were hitherto considered “off-limits,” such as the urban ration prices of grain and various energy products, were adjusted. More recently, grain prices have been completely liberalized in several provinces. In addition to rationalizing the price system, some steps were taken to increase the exposure of the SOEs to the market and to make them responsible for their profits and losses.

The acceleration of reforms once again fueled an investment boom that by and large was accommodated by expansionary domestic financial policies. The growth of fixed investment reached 24 percent in 1992 in real terms and accelerated further, to about 40 percent, in the first half of 1993. Credit growth exceeded the plan target, and credit creation by nonbank financial intermediaries not covered by the credit plan grew rapidly, as evidenced by the increasing divergence between the growth rates of domestic credit and net domestic assets.

Signs that the economy was being stretched to its limits began to emerge during 1992 in the form of shortages in critical areas such as transportation, energy, and industrial raw materials. Inflation accelerated, especially during the first half of 1993, when the 12–month rate of change in the national retail price index was over 10 percent, and the urban cost of living index surged to almost 20 percent (Table 20). At the same time, import growth topped 25 percent, and export growth progressively slowed to below 10 percent as goods were diverted toward domestic markets.

Table 20.

Selected Recent Economic Indicators

(Percentage change over 12 months, unless otherwise specified)

Sources: State Statistical Bureau newsletter, various issues; and data provided by the Chinese authorities.

Change for whole year.

Change in first quarter of 1993.

Change in first half of 1993.

Effective mid-May 1993.

Effective July 10, 1993.

For lending of one year’s maturity.

Consequently, a deficit emerged in the trade account for the first time since 1989. Pressure in the foreign exchange market manifested itself both in the loss of official foreign exchange reserves relative to their peak in mid-1992 and in the sharp depreciation of the renminbi in swap markets by nearly 75 percent between April 1992 and June 1993. Signs of growing financial disintermediation also emerged as shown by declines in household savings deposits and the surge in demand for gold and real estate.

Amid deepening concern about the intensification of demand pressures, the authorities implemented small increases in interest rates on deposits and loans in May and again in July 1993. Other measures that were announced as part of the austerity program included reducing government expenditure by 20 percent, postponing price reforms planned for the second half of the year, limiting the number of permitted development zones, strengthening the central bank to ensure that the credit plan was adhered to and to limit credit expansion through non-bank financial intermediaries, eliminating the issuance of IOUs to farmers, strengthening the enforcement of capital gains taxes on real estate transactions, requiring loans for speculative real estate purchases to be repaid, and completing government bond sales through compulsory placement with state employees. It remains to be seen whether these measures will be sufficient to deal with the overheating, to ensure that the Chinese economy will achieve a “soft landing,” and that the pace of reform will not be adversely affected.

Understanding the Cycles

At each stage in the reform process, measures emphasizing decentralization and devolution of powers and diminishing the role of the plan were followed by a surge in aggregate demand—reflecting feverish investment growth and wage increases. In general, acceleration in the reform process has been taken as a carte blanche for more rapid investment both by the state and nonstate sector.

At the same time, market-based macroeconomic management has been hampered by the incompleteness of the reforms. The issue here is not so much that there is a paucity of market-based policy instruments but rather that the mechanisms by which changes in these policy instruments are transmitted to real economic activity—interest rates, relative commodity prices, and exchange rates—do not always reflect underlying demand and supply conditions. Furthermore, many economic agents are not subject to the discipline of the market and therefore cannot respond to the price signals as much as would be expected in a fully market-based system. This, together with the lack of adequate legal and regulatory institutional infrastructure, has led the authorities to resort to administrative measures to control the pace of economic activity.

In addition, the implementation of some aspects of the reforms, notably of the tax system, have led to perverse automatic stabilizers. For example, the introduction of the contract responsibility system resulted in a reduction in the income elasticity of the tax system. In theory, under the contract responsibility system, profits up to the predetermined quota are taxed at a flat rate; profits above this limit are taxed at much lower rates. However, most enterprise income tax payments took the form of negotiated contracts specifying tax payments in nominal terms. To soften the impact of increased borrowing to finance enterprise investment, amortization payments were made tax deductible.

Under these arrangements, as output and profits expand, enterprises tend to retain a larger portion of their profits, which leads to an income elasticity of less than unity for the enterprise profit tax. Similarly, so long as enterprises continue to face soft budget constraints, and the tax system is not broadened and rationalized, fiscal policy will have to continue to rely on expenditure cuts to control aggregate demand. Incomplete price reform and the resultant subsidies to consumers and enterprises have implied that expenditure cuts have to be concentrated in investment outlays with deleterious consequences for basic infrastructure.

Why should one be concerned with these bouts of macroeconomic instability when China has managed to sustain high growth rates throughout the period since reform began? The impact of “stop-go” reforms on production and resource allocation is disguised by measured growth rates, which, albeit fluctuating, remained positive even in the trough of the cycles. First, growth rates were artificially sustained in recession to protect employment through preferential credit policies. Second, measured growth rates did not reflect the continued production of large quantities of substandard and unmarketable goods by state-owned enterprises, which gave rise to interenterprise arrears and nonperforming assets in banks’ portfolios. Third, in light of frequent changes in the direction of policy, investment decisions tended to be based on short-term considerations, with potentially adverse implications for the efficiency of resource allocation. Fourth, without market-based instruments of macroeconomic management, the authorities relied on direct credit controls that do not distinguish between more and less efficient borrowers. Inefficiencies in resource allocation were further aggravated as some loss-making state enterprises were supported through preferential credit. The sharp contraction in the growth of output and employment in the TVE sector during the rectification program of 1988–89 was a good example.

Structural Reforms to Promote Market-Based Macromanagement

China’s experience with periodic bouts of inflation and external payments disequilibria during the implementation of reform leads to two generalizations. First, incomplete reforms heighten the risk of macroeconomic imbalances emerging. Reforms must therefore be as comprehensive as possible and must include at an early stage the development of indirect instruments with which to regulate the economy. Second, the instability stems not so much from too rapid a pace of reform but rather from excessive demand growth as new reforms are initiated. This suggests that, inasmuch as reforms do proceed in stages, new phases of reform should be accompanied by appropriately tight financial policies.

The critical issue now involves the steps that China must take to develop the capability to manage its economy through indirect means. This need has been made more acute because as economic reforms have deepened and decentralization has accelerated, administrative controls are becoming less effective leaving the authorities no choice but to rely on more market-based instruments for macroeconomic control. However, such instruments cannot work as intended without certain critical enabling structural reforms in the sectors discussed below (many of which are already being actively considered by China’s policymakers and are covered in detail in Section III).

Financial Sector

The steps that would be essential to improving the functioning of financial markets are, first, strengthened competition in the banking sector, inter alia, by reducing the degree of specialization among the major banks and allowing them greater flexibility in setting their lending and deposit rates; second, measures should be implemented to facilitate the growth of well-functioning financial markets for interbank transactions and for short-term bills, and an appropriate legal and regulatory framework should be established. The key to successful reform in this area would be to free the specialized banks from the obligations to undertake “policy lending,” or, more generally, quasi-fiscal operations at the behest of the Government in support of specific policies, sectors, or enterprises.

For a time, while the groundwork is being laid for the development of indirect instruments, it will undoubtedly be necessary for the authorities to use a combination of both direct and indirect instruments. Even so, available direct instruments can be altered somewhat to minimize their distortionary effects and increase their effectiveness. During the transitional period when it is necessary to rely on the credit plan, key steps would be (1) to expand the coverage of the credit plan to include credit to the Government;109 (2) to begin phasing out the industry- and sector-specific allocative guidelines within the overall credit plan; and (3) to strengthen the institutional capacity of the People’s Bank to implement the credit plan by enhancing headquarters control over its provincial branches.

Enterprise Reform

Market-based instruments of monetary and fiscal policy will only be effective if enterprises are subject to the discipline of the market. Enterprise reform should therefore focus on eliminating, as quickly as possible, the two key sources of operating losses by reducing, first, price distortions arising from continued price controls, and second, the inefficiency of individual enterprises associated, inter alia, with a soft budget constraint.

The first involves accelerating further the time frame for price adjustments of energy products and transportation, as the majority of SOE losses are concentrated in these sectors. For the second, the approach should be to harden SOEs’ budget constraints while granting them greater autonomy. This approach would entail encouraging banks to deny credit to uncreditworthy clients and phasing out subsidies for loss-making SOEs. In addition, the authorities would need to accept some enterprise closures and labor force retrenchment as an outcome of these reforms. In this context, providing an adequate social safety net and creating conditions conducive to greater labor mobility—notably by establishing arrangements for pensions, health insurance, housing, and so forth, which are independent of individual work units—are crucial.

Fiscal Reform

To strengthen the role of the budget in macroeconomic management, it is necessary to tackle the problems of the lack of revenue buoyancy, the erosion in the central government’s share of fiscal revenue, and the high subsidy payments. First, it will be necessary to abandon the contract system of taxation and move to a uniform enterprise income tax. Not only would this broaden the tax base and increase the elasticity of the tax system but it would also ensure that the tax system functions as an automatic stabilizer. The introduction of other direct and indirect taxes would also contribute. Second, the current revenue-sharing contracts with the provinces need to be replaced through the clearer delineation of revenue sources for central and local governments. Third, further significant price reforms, particularly in the area of energy and transportation pricing, will need to be implemented to reduce the burden of subsidies on the budget.

External Sector Policies

A more open and liberal trade and exchange system would provide an additional safety valve, that is, a mechanism for automatic adjustment in the economy and would therefore obviate the need to resort periodically to the use of administrative controls on imports and the exchange rate. Import liberalization would, for example, relieve bottlenecks in the key sectors. The present comfortable level of foreign exchange reserves make this an opportune time to consider such liberalization. Similarly, a less restrictive exchange system would increase the role of exchange rates in regulating aggregate demand. Critical steps in this regard include allowing access to swap markets for all current account transactions, increasing the foreign exchange retention ratio to 100 percent, phasing out the foreign exchange plan, progressively reducing the amount of retention quotas that exporters must sell to the state at the prevailing swap rate, replacing the retention quotas with cash retention, and developing an interbank market in foreign exchange.

Cited By

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