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We would like to thank Stanley Black, Ralph Chami, Norbert Funke, Magda Kandil, Mohsin S. Khan, Mounir Rached, Markus Rodlauer, Sunil Sharma, and Harm Zebregs for helpful comments and suggestions.
Defined to include macroeconomic adjustment policies as well as structural reforms.
It is difficult to determine whether the Chinese real exchange rate is over or undervalued. There has been a significant increase in foreign exchange reserves. At the same time, however, existing capital controls complicate an evaluation of the appropriate exchange rate level.
It is beyond the scope of this paper to fully analyze Chinese decentralization. For a review of Chinese fiscal decentralization, see Bell, Khor and Kochhar (1993), Lardy (1998), Tseng and others (1994), Hofman (1993), and World Bank (1994, 1996). A broad historical and analytical survey of Chinese fiscal and macroeconomic policies is given in J. Ma (1997).
See Groves and others (1994), Dollar (1990) and Jefferson and others (1999) for further discussion of changes in Chinese productivity. The general relationship between fiscal policy and growth is examined in Easterly and Rebelo (1993).
Such a mechanism is described in Brandt and Zhu (2000), who say, “Employment and investment growth in China’s inefficient state sector have been supported by the government with transfers in the form of cheap credits from the state-owned banks and money creation. While this increases output growth, it also forces the government to rely more heavily on money creation to finance the transfers to the state sector, which causes inflation to increase as well.” World Bank (1994) maintains that China’s inflation can be explained by the effect of decentralization on both the public sector deficit and control over monetary expansion. Having no independent central bank, China controls monetary expansion by setting credit ceilings and controlling interest rates. The credit plan designed by the People’s Bank of China, the State Planning Commission, and the Ministry of Finance has been weakened by state-owned enterprises and local governments, which do not respect credit limits. Pressure to support distressed state enterprises has resulted in budget subsidies and the granting of soft loans. Because their own on-hand deposits are typically insufficient to cover credits, banks often seek extra funds from the People’s Bank of China, leading to money creation and inflation.
We do not tackle the issue of quantitative restrictions.
The basic structure of this model, in a non-transition economy, is developed in Blejer, Feldman, and Feltenstein (2000) and Ball and Feltenstein (2000).
We wish to avoid using a single, perfectly mobile, capital type since it would generate overly rapid sectoral adjustments.
The use of neoclassical value added functions “sitting above” an input-output matrix is common. The reader may wish to see Shoven and Whalley (1984) for articles that use this approach.
The interpretation of these taxes is thus as a profit tax and a personal income tax that is withheld at the source.
For simplicity, the model assumes that all foreign borrowing is carried out by the government, so that, implicitly, the government is borrowing for the private investor but the debt incurred is publicly guaranteed. The Chinese Government, however, does not in practice borrow on behalf of the private sector in China.
We could have other types of expectational mechanisms, such as one in which the firm uses the trends of past prices to predict those for the future after period 2.
Clearly these percentages are arbitrary and should serve only for illustrative purposes. We could have any initial pattern of distribution of bank assets across the different sectors.
The rational for this approach is that banks are aware that depositors will withdraw their deposits if they believe bank assets are risky. In order to reduce these withdrawals, the banks in turn ration credit to risky borrowers. Our approach is a simple version of that presented in Calomiris and Wilson (1998). In fact, Chinese depositors, who have no alternative to the banking system, are unlikely to withdraw their deposits. In addition, banks continue to make loans to public enterprises in China. Furthermore, the capital adequacy ratios in the Chinese banking system are low.
We are thus abstracting from any uncertainty across firms, as well as any notion of private information about those firms. The only information banks possess about firms is their stock of defaulted assets.
Clearly δk is not derived from optimization, but is taken to be exogenous and does not vary over time.
This figure of α percent is taken simply to correspond to standard bank regulations. That is, if the average ratio of capital to total assets in the banking system is approximately a percent, then an α percent loss of assets would be tantamount to a total liquidation of capital. In practice, a figure of 8 percent is generally used by regulators in the United States.
This reflects the notion that the consumer worries about the safety of his own deposits as he sees the banks become progressively more insolvent.
Since the only information the consumer has about the future is the real interest rate, adoptive expectations is, in this case, equivalent to rational expectations.
As before, 1 denotes period i and 2 denotes period i+1.
We also permit sterilization of foreign reserve flows. This may be an important policy instrument in a country such as China, which has enormous stocks of foreign reserves.
The solution is derived by the use of a computer program written by Andrew Feltenstein. The program is written in FORTRAN 90 and both the program and the Chinese data set are available from the authors.
The utilities are calculated as the present value of the stream of consumption over the time periods of the simulation. The consumer’s rate of time preference is the discount factor.
The long-run sustainability of the current account could be checked by running simulations over a considerably longer time period than the six periods examined in this study.
Trade barriers in China are incorporated as nontariff barriers rather than as high tariff rates. Hence trade liberalization should really be studied as a reduction in quantitative restrictions. Such simulations, however, are beyond the scope of our current study.