Prices and demand respond to liberalization of trade policy in China

In a statement issued on March 8, IMF Managing Director Michel Camdessus announced his intention to recommend to the IMF Executive Board that it approve the revised economic program for 1999-2001 proposed by the Brazilian government. The text of News Brief 99/10 follows.

Abstract

In a statement issued on March 8, IMF Managing Director Michel Camdessus announced his intention to recommend to the IMF Executive Board that it approve the revised economic program for 1999-2001 proposed by the Brazilian government. The text of News Brief 99/10 follows.

How responsive have China’s relative prices and domestic and foreign demand been to the liberalization of foreign trade over the past two decades? Valerie Cerra of the IMF’s European I Department and Anuradha Dayal-Gulati of the IMF Institute examine these issues in a recent study, China’s Trade Flows: Changing Sensitivities and the Reform Process. They find that while in 1979, China’s foreign trade functioned according to a crucial plan that determined what was exported and what was imported, today, market forces determine the price of exports and imports and, to a large extent, their composition. Although some restrictions on imports remain, China has become a substantially open economy, with the share of merchandise trade in GDP tripling over the past two decades, from 10 percent in 1979 to 36 percent in 1997.

Prereform policies

Before the reform movement, China’s foreign trade was guided by a central plan that ensured that exports generated sufficient foreign exchange to meet the country’s import requirements. Exporters supplied targeted quantities to 12 foreign trade corporations, and all foreign exchange receipts from the sale of these exports were surrendered to the central bank at the official exchange rate, later to be disbursed in fulfillment of the import plan.

The import plan identified imports of food, raw materials, and intermediate goods to fill the gap between domestic production and domestic demand. The foreign trade corporations were not free to determine which goods were to be exported or the price at which these goods were to be procured from domestic manufacturers. Export losses occurred when these corporations were required to buy such goods as electronics or machinery from inefficient producers at relatively high prices and to sell them at lower prices in the international market. Moreover, since imports were intended mainly to fill a demand gap, the foreign trade corporations had to purchase imports at international market prices and sell them at administratively determined domestic prices, of ten incurring substantial losses.

1984-85 reforms

In 1984, the authorities began seriously to liberalize the foreign trade regime, the authors note. First, they relaxed the import plan, freeing more foreign exchange for non-mandatory imports. In 1984, local governments were granted the right to retain a share of the foreign exchange earned in their region and, in 1985, this right was extended to exporting enterprises. Under this system of retention quotas, local authorities and enterprises could purchase from the central bank, at the prevailing exchange rate, foreign exchange equal to 25 percent of their export earnings. This foreign exchange could then be used to purchase imports outside the plan.

Second, the monopolistic position of most foreign trade corporations was abolished, allowing branches of these corporations to act as agents of domestic enterprises, particularly in purchasing imports. The foreign trade corporations now charged a fee for their services, but would not absorb profits or losses on goods traded.

Under the 1984 reforms, about 60 percent of exports fell under a mandatory plan, an additional 20 percent were assigned as value targets to individual provinces, and the remainder were nonplan exports. The procurement price of mandatory exports was fixed, but could be negotiated for nonmandatory exports. Given the large share of mandatory exports routed through the designated foreign trade corporations, however, the 1984 reforms failed to establish a close systematic rela-tionship between relative prices and export volumes.

Importers could choose any foreign trade corporation for procuring nonmandatory imports, as long as they could pay the import price and the corporation’s costs. With the decentralization of the foreign trade system, foreign trade corporations proliferated and the agency system for nonmandatory imports became widespread. The increased share of imports channeled through the agency system meant that consumers rather than foreign trade corporations directly absorbed variations in international market prices and fluctuations in the exchange rate.

The value of imports shot up by over 60 percent in 1985 (although exports remained stagnant). Imports surged partly because foreign exchange was available at the depreciated official rate through retention quotas. The sharp deterioration in the trade balance led the government to apply stricter trade controls. Credit was tightened, and import bans, quotas, and licenses were used to restrict imports, whose growth fell during 1986—87.

Later reforms

Additional wide-ranging reforms in 1988 included increased retention of foreign exchange and a reduction of mandatory exports by about 30 percent. Moreover, access was eased to foreign exchange adjustment centers (established in 1986), in which enterprises were allowed to buy and sell foreign exchange at a depreciated rate known as the swap rate.

To encourage exports, the authorities raised retention quotas for enterprises that exceeded their targets, for priority sectors, and for higher domestic value-added products, such as home electronics (100 percent retention) and garments (60 percent retention). Increased retention quotas and liberalized access to foreign exchange adjustment centers meant that the effective exchange rate received by the exporter was a weighted average of the official exchange rate and the depreciated swap rate. The central government continued to subsidize losses on mandatory exports at an ever-decreasing rate until these subsidies were abolished in 1991, along with the entire mandatory export plan.

The 1988 reforms represented a major step toward making exports more responsive to relative prices. Growth in the volume of exports increased to about 13 percent in 1988 from an average of 7 percent in the previous five years. The increase in the retention quota would probably not have provided significant export incentives unless the foreign trade corporations passed on these benefits to manufacturers through higher procurement prices. The abolition of the mandatory export plan and of export subsidies in 1991 created livelier competition among the foreign trade corporations in purchasing products and more attractive prices for export suppliers. Export volumes rose by about 16 percent in 1991 relative to about 7 percent in the previous year.

To limit the impact of foreign trade corporation losses on the central government budget, the scaling back of the import plan was accompanied by a gradual increase in domestic prices. In 1989-90, the domestic prices of steel, nonferrous metals, and several other products were raised to international market prices. In 1991, subsidies for imported food grains and vegetable oils were further reduced. Prices for imported goods in line with international prices are likely to have increased the responsiveness of import volumes to changes in relative prices.

1994 reforms

In January 1994, the exchange rate was unified at the prevailing swap-market rate, which led to a depreciation in the official exchange rate of about 50 percent. The retention quota system for foreign exchange was abolished, and the tax system was revised to allow a zero value-added-tax (VAT) rating for exports by domestic firms and newly established foreign-funded enterprises. This tax change meant that exporters could claim a refund of the VAT paid on inputs. These reforms led to a vigorous pickup in exports. Domestic enterprises had faced an exchange rate that was the weighted average of the official rate and the swap rate, as noted above. Foreign-funded enterprises, in contrast, were not subject to retention quotas and were allowed to retain the full amount of their export earnings. The unification of the exchange rate in 1994 therefore had a greater effect on export performance of the enterprises that were not foreign funded, contributing to a surplus in this sector.

The 1994 reform eliminated mandatory import planning and reduced quotas and licensing requirements. Tariff rates were reduced for a few products and nontariff barriers were lowered.

Foreign direct investment policies

In addition to the liberalization of the trade and exchange rate regime, China’s open-door policy toward foreign direct investment has been a significant component of its external sector reform. The policy focus of the first phase of foreign direct investment flows, during 1979-85, was to attract foreign investment for natural resource development and the export sector. Nevertheless, foreign investment remained slow until 1983 because of a lack of appropriate labor skills and infrastructure, but a shift in China’s investment policies after 1983 hastened these flows. Special tax incentives to encourage foreign investment in technology-intensive industries were introduced. Firms operating in special economic zones were given more generous tariff concessions, more flexible labor relations, liberal land-use rights, lower income tax rates, and tax holidays. Largely as a result of these initiatives, foreign direct investment inflows had increased to over $4 billion by 1991. Since 1992, further liberalization has taken place and open economic zones have proliferated rapidly, typically without approval from the central government. In 1997, net foreign direct investment flows rose to more than $40 billion.

Cerra and Dayal-Gulati suggest that the responsiveness of China’s exports and imports to the real effective ex-change rate has increased over time, owing to farsighted policy changes. The continued transition to a more mar- ket-oriented economy is likely to intensify the responsive- ness of domestic enterprises to market signals.

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March 22, 1999

Copies of Working Paper 99/1, China’s Trade Flows: Changing Price Sensitivities and the Reform Process, by Valerie Cerra and Anuradha Dayal-Gulati, are available for $7.00 each from IMF Publication Services. See page 92 for ordering information.

IMF Survey: Volume 28, Issue 06
Author: International Monetary Fund. External Relations Dept.