Arthur J. Rolnick - Senior Vice President and Director of Research, 1985-2010
Published December 1, 2003 | December 2003 issue
In December 1978, exactly 25 years ago, China's economic leaders began their journey from central planning to free markets. A long march at a sprinter's pace, the process of economic change in China has been nothing short of breathtaking.
In just a quarter century, China has grown from virtual autarky to the world's fifth largest trading partner and largest recipient of foreign direct investment. From 1978 to 2001, its gross domestic product grew from one-eighth to over half that of the United States, making China the world's second largest national economy. Within a dozen years, by some estimates, it will be the world's largest.
The results are globally apparent. Chinese skirts fill malls in Muncie; American franchises sell burgers in Beijing; European and Japanese manufacturers are investing billions on production and research facilities in China's largest cities; Chile's copper exports to China have soared. And months ago, China shot into orbit with its first manned space flight—only the third nation on earth to do so—a mark of political determination, scientific prowess and economic vigor.
The People's Bank of China, the nation's central bank, has been a key—if obscure—actor in this remarkable transformation. And in coming years, the PBOC is likely to play a still more critical role as the nation's financial sector opens up to international competition, as state-owned banks address their bad loan troubles and as world leaders exert continued pressure on China to revalue its currency.
In March 2003, the Minneapolis Fed's Art Rolnick met with PBOC director-general of research, Ping Xie, in Beijing and there began an extended conversation about China's central banking practices and policies. The exchange printed below was conducted in writing, with questions and answers traded over a number of months. Mr. Xie's comments, translated from Chinese, cover issues ranging from central bank structure and interest rate liberalization to deflation and deficits. It is a rare glimpse into the complex state of affairs of the world's most dynamic economy.
Rolnick: In the United States, our Federal Reserve System comprises 12 regional banks and 25 branches under the oversight of the Board of Governors. The regional banks are the operating arms of the System and they also conduct research, and their presidents attend meetings of the Federal Open Market Committee, which establishes monetary goals for the country. For our understanding, could you briefly describe the structure of the People's Bank of China? Does it have regional banks, for instance, and which unit of the PBOC sets monetary policy?
Xie: The People's Bank of China comprises nine regional banks, 328 central branch banks and 1,811 county branch banks. Before 1998, regional banks of the PBOC were located in each province—that is, every province had a separate regional bank, whose business was susceptible to intervention by local government. In 1998, this was changed. Nine regional banks were established in nine relatively developed provinces, and each of them supervises two to five provinces. The goal of this reform is to strengthen the independence of the PBOC to carry out monetary policy, and financial control and management. This past April, the China Banking Regulatory Commission was newly created specifically to manage deposit financial institutions. The PBOC will no longer oversee these kinds of institutions. This reform changed the functions of the PBOC but didn't affect its overall structure.
There is a Monetary Policy Commission inside the PBOC, chaired by the governor of the PBOC. The members include [officials from] the Ministry of Finance, State Development and Reform Commission, Securities Regulatory Commission, Insurance Regulatory Commission, main financial institutions, State Administration of Foreign Exchange as well as academic experts. The Monetary Policy Commission is not a decision-making body, but a consulting institution. It has one regular meeting every quarter and provides advice on monetary policy. It is the Monetary Policy Department inside the PBOC [not the Commission] that is in charge of issues related to monetary policy.
Rolnick: As you know, the Federal Reserve manages the money supply largely through its open market activities. Could you explain the mechanisms that China uses to inject money into the economy? To what extent is it accomplished through fiscal policies rather than central bank mechanisms?
Xie: The People's Bank of China has gradually changed from direct control to indirect control of the macroeconomy. In 1998, it ended controls on loan limits. Currently the PBOC utilizes a combination of central bank loans, rediscounting, open market operations, interest rates, exchange rates and lending policy to control the macroeconomy.
In the first half of 2003, the growth rate of M2 increased by 20.8 percent, the highest since 1998. The total amount of new loans was renminbi (RMB)1.8 trillion and the growth rate was 22.9 percent. The foreign reserve balance was US$346.5 billion. And base money increased by RMB387.6 billion. To maintain economic stability and prevent financial crisis, the PBOC adopted appropriate counter policies. Through open market operations in the first half year, the PBOC withdrew RMB277.8 billion in base money. On Sept. 21, the PBOC increased the deposit reserve ratio from 6 percent to 7 percent. Assuming the deposit balance is RMB15 trillion this year, we will withdraw about RMB150 billion in base money.
Fiscal policy and monetary policy are two important tools used to control the macroeconomy. Our fiscal and monetary policies are independent but also coordinated with one another. After 1998, in order to increase domestic demand and support the economy's steady growth in the context of a declining consumer price index (CPI), China decided to implement proactive fiscal policies and sound monetary policies. Since May 1996, the PBOC has decreased the interest rate on deposits and loans eight times. In terms of fiscal policies, from 1998 to 2002, China issued government bonds in the amount of RMB660 billion in total, which were mainly used to finance infrastructure. Evidence has shown that the coordination of fiscal and monetary policy is crucial for supporting steady economic growth. In recent years the growth rate of gross domestic product (GDP) has remained steady at about 8 percent per year.
Rolnick: In the United States, we go to great pains to preserve the independence of central bank policy and practice. Given a very dissimilar history and political structure, I imagine the situation might be quite different in China. To what extent is the People's Bank of China truly independent from the fiscal authorities that make tax and spending decisions?
Xie: China and the United States have different political, economic and historical situations, which are reflected in the independence of their respective central banks. The independence of the People's Bank of China is greatly different from that of the Federal Reserve System of the United States. When we talk about independence of the central bank, we mean the relationship between the central bank and the government. It is believed worldwide that central banks should maintain relatively high independence. I agree with this. But from another point of view, independence is relative. Absolute independence does not exist. In China, the PBOC has partial independence. The PBOC is one of the departments under the State Council. Interest rate and exchange rate policy must be approved by the State Council. The PBOC decides other monetary policies independently. According to the People's Bank of China Act [of 1995], the government can't overdraft from the PBOC.
Rolnick: For some time now, the yuan (or renminbi) has been in a "managed float" relative to the dollar, trading in a narrow band of 8.27 to 8.28 yuan to the dollar. China has faced criticism for this—some argue that the yuan is undervalued, and others say it is overvalued. But both these perspectives imply that the exchange rate should float freely, rather than being managed in such a narrow range relative to the dollar.
What is your perspective on the best policy regime: fixed or floating rates? And what is the likelihood of allowing the yuan to float—or at least to widen the band in which it trades—in the near future?
Xie: Since unification of the two-track exchange rate in 1994, we have implemented a managed float exchange rate based on market demand and supply. The renminbi exchange rate is basically determined by the market. After the unification, the renminbi exchange rate is relatively flexible, changing with respect to different currencies to varying extents. Therefore, the renminbi exchange rate is flexible, not fixed. Overall, the renminbi is appreciating relative to the currencies of China's main trading partners. From the beginning of 1994 to the end of 2002, the nominal appreciation rates of the renminbi to the dollar, euro (German mark before euro) and yen are 5.1 percent, 17.9 percent and 17.0 percent, respectively. In real terms, the appreciation rates are 18.5 percent, 39.4 percent and 62.9 percent, respectively.
Since 1998, the nominal exchange rate of the renminbi to the dollar has been stable with little fluctuation. There are special reasons for this narrow float band. In 1997, the Asian financial crisis broke out and spread continuously. Many East Asian country currencies depreciated greatly, which increased expectations of a drastic renminbi depreciation. The government of China promised no renminbi depreciation, increased control over the exchange rate and thereby successfully maintained the stability of the renminbi exchange rate. This contributed to the stability of Asia's—and even the world's—economic and financial systems. After the Asian crisis, China continued its stable renminbi exchange rate policy. In fact, the stability of the renminbi contributes to the sustainable and steady development not only of China, but also of surrounding countries and, fundamentally, to world economic stability and growth.
Recently, international groups [including international agencies, foreign governments and businesses] have begun to pay attention to the renminbi exchange rate. The Chinese government has been very prudent on this matter. It is worth pointing out that some arguments about the renminbi exchange rate are obviously not well-grounded. The renminbi exchange rate won't be revalued in the near future.
From this point forward, we will adapt to the evolving international situation and explore and improve the renminbi exchange rate mechanisms under the prerequisite of a stable exchange rate. We will actively facilitate trade and investment, increase marketization of exchange rates, develop foreign exchange markets, deepen and widen the reform of exchange rate markets, use better methods in managing exchange rates, coordinate interest rate policy and exchange rate policy, develop money and capital markets, speed up the appropriate reforms and promote the coordination of the internal and external economy.
Rolnick: As a follow-up question, I'd like to ask you about Hong Kong, which has its own currency. How long will it be before there is a single currency for all of China?
Xie: This situation [of one country with two different currencies] will last for more than 50 years. According to the Basic Law of Hong Kong, Hong Kong's social and political policies ... will not change over the next 50 years. The government of the Hong Kong Special Administrative Region has a highly independent monetary policy and exchange rate policy.
The Hong Kong Special Administrative Region government has no intention of changing the current system of a linked exchange rate [between the U.S. dollar and the Hong Kong dollar]. Although there are some unofficial and academic debates about the exchange rate system, both the mainland and Hong Kong governments have not put these questions on the agenda.
Rolnick: Four major Chinese banks—the Bank of China, the Industrial and Commercial Bank of China, the Agricultural Bank of China and the China Construction Bank—have been in serious financial trouble for some time now; official estimates are that they carry bad debt equal to about 25 percent of their loans. Until recently, the People's Bank of China has been considering whether to create a rescue package for those banks; now that policy consideration will likely be shifted to the newly formed China Banking Regulatory Commission.
But rescuing banks in distress—while helpful to the banks and initially stabilizing for the economy—can create the perception that some banks are too big to fail, and the problem of moral hazard: the idea that banks will continue to take undue risks in the belief that they will be bailed out. These are problems that have long been concerns for policymakers at the Federal Reserve System in the United States.
I'd be interested to learn your perspective on this issue. How should bank regulators balance the need to deal with banks in lending trouble—and the possible spread of panic should they fail—with the need to prevent the perception that the government will always come to the rescue?
The bad debt of China's bank system
After almost eight years of hard work since the Chinese banking management meeting in 1995 first proposed that the bad debt of the four state-owned commercial banks be lowered, financial management departments and all commercial banks have achieved a remarkable level of success.
At the end of 2001, the balance and the ratio of bad debt of the four state-owned banks decreased for the first time: The bad-debt balance decreased by 90.7 billion yuan relative to the beginning of the year, and the bad-debt ratio decreased by 3.81 percent.
At the end of 2002, the bad-debt ratio of the four state-owned commercial banks was 21.41 percent, a 3.95 percent decrease from the beginning of the year; the bad-debt rate of the 11 joint-stock commercial banks was 9.5 percent, a 3.44 percent decrease from the previous year; the bad-debt ratio of the 111 city commercial banks was 17.7 percent, a 6.33 percent decrease from the beginning of the year.
At the end of June 2003, the bad-debt ratio of the four state-owned banks (according to the five-category assets classification) was 22.19 percent, a 4.02 percent decline since the beginning of the year*; the bad-debt ratio of the policy banks was 18.61 percent, down by 1.18 percent; the bad-debt ratio of the joint-stock commercial banks was 9.34 percent, a 3.15 percent drop; the bad-debt ratio of the 112 city commercial banks was 15.88 percent, a 7.18 percent decrease relative to the same period in 2002, which achieved the first-stage objective of decreasing the bad-debt ratio.
However, the bad-debt ratio of Chinese banks is still relatively high. The international consensus on a warning level for bad-debt [to total debt] ratio is around 10 percent.
Disposition of nonperforming loans in China
1. Establish four asset management corporations.
In 1999, to reduce risks associated with the nonperforming loan situation in the Chinese banking system, China established four asset management corporations (AMCs), which specialize in buying, managing and disposing of the nonperforming loans of the state-owned commercial banks.
The AMCs bought about RMB1.4 trillion of nonperforming loans of the state-owned commercial banks, in accordance with the purchasing limit set by the government. They then began to dispose of these nonperforming loans according to commercial standards. The methods of disposal include leasing, contracting-out, restructuring, debt-equity swaps, holding security claims of the firms temporarily, transforming assets into securities, etc. As of the end of June 2003, the four AMCs had disposed of RMB361.841 billion of nonperforming loans (excluding debt-equity swaps undertaken for policy reasons), had withdrawn capital in the amount of RMB112.532 billion, and had taken back RMB79.229 billion in cash through auctions in domestic and international markets, joint ventures, restructuring and many other innovative methods.
2. Disposition methods for nonseparated bad debt.
Although four AMCs were established to dispose of the nonperforming loans of the Big Four state-owned commercial banks, they haven't eliminated all NPLs. Currently, their NPL balance remains rather high. The Big Four have designed a professional disposal method to decrease NPLs through emphasizing their cleanup and management.
Deepening reform, avoiding the emergence of new nonperforming
1. Implement the five-category loan classification system and reflect loan quality accurately.
On Jan. 1, 2002, China expanded the five-category loan classification management system to the entire banking industry to guarantee accurate loan quality statistics. In 2002, four state-owned commercial banks and 11 joint-stock commercial banks were in the early stages of adopting the five-category system and using it on a daily basis. The Banking Regulatory Commission has announced that the five-category loan classification system will be fully adopted in 2004, and the previous loan classifications will be abolished.
2. Actively disseminate prudent accounting systems; clean up NPLs and nonloan assets according to prudent accounting standards and collect interest according to related rules; increase bad-debt reserve ratios; speed up the elimination of bad-debt loans; strengthen control of the capital sufficiency rate of commercial banks; and strengthen capital controls. The ratio of nonperforming loans to total loans must drop 2 percent to 3 percent each year for the bad-debt ratio to decrease to 15 percent by 2005.
3. Strengthen loan management and avoid the emergence of new nonperforming loans.
Commercial banks should: Improve their authorization and loan examination mechanisms; establish and improve their systems for bank inquiry and registration, and credit risk evaluation; terminate lending to high-risk customers in a timely manner; gradually improve loan management by separating the supervision and loan-granting systems, and by investigating loans carefully; improve the accountability of loan clerks and create effective incentives for them; examine the granting and repayment of loans and ensure good quality of new loans.
In sum, maintain the stability of the economy by lowering the nonperforming loan ratio gradually in the process of supporting the growth of the economy and banking development; speed up the reform of state-owned enterprises and adjustment of the economic structure; eliminate the source of nonperforming loans; prevent moral hazard; establish a good credit environment; punish firms that default on their debt; improve the legal system to protect lenders' interests; deepen the reform of state-owned commercial banks; and increase the risk management capacity of commercial banks. At the same time, insist on early risk identification as well as risk warning and control, and, in particular, monitor risk control and management inside banks.
The People's Bank of China will fulfill its role as a central bank in controlling the macroeconomy and avoiding financial risks. At the same time, it will strengthen its functions in formulation and implementation of monetary policy, and continuously improve rules for related financial institutions and improve financial macro control policies. The PBOC and the Banking Regulatory Commission will establish a close relationship, share information on financial market risks and operating situations in a timely manner, and together maintain the safety of the financial system.
Rolnick: Under traditional planning practices, China has set benchmark lending rates with little or no flexibility for banks or other financial institutions to vary interest rates according to their assessment of the lending risk involved. China's one-year yuan term deposit, for example, is set at 1.98 percent with no variation allowed.
But the People's Bank of China has identified "progressively pushing through reform of the interest rate regulatory regime" as a necessary task in sustaining economic growth. What steps will the PBOC take to reform the interest rate regime?
In that regard, could you tell us about the experiments you have conducted in rural counties with flexibility in lending rates? Will this experiment be expanded?
Xie: The objective of market-based interest rate reform is to establish an interest rate formation mechanism in which market demand and supply decide the deposit and loan rates of financial institutions. The People's Bank of China will control and adjust the market rate using monetary policy and make the market play a critical role in the allocation of financial resources. The basic rule of the reform is to deal correctly with the relationship among market-based interest rate reform, the stability of financial markets and the healthy development of financial institutions to properly coordinate domestic and foreign interest rate policy, and to gradually reduce the fiscal role of interest rate policy. The steps of the market-based interest rate reform are: first foreign currency, then domestic currency; first lending, then deposit; first long-term, large-deposit, then short term, small-deposit.
In recent years, the PBOC has tried to carry out market-based interest rate reform by widening the float ranges for both deposit and lending rates at financial institutions and by decentralizing authority over interest rate float; at the same time, the PBOC has improved interest rate management. In 1996, the borrowing rate between banks was freed from government control so that the rate depended on market demand and supply; then interest rates on discount and rediscount notes and interbank loans were freed up and policy-oriented financial debts and government bonds were issued by auction.
The interest rate reform plan allowed the float scope of financial institution lending rates to widen gradually, and financial institutions' independence in determining the interest rate was also increased gradually. For example, the lending rate float range for loans to small or medium-sized firms was widened, as it was for county financial institutions and rural credit cooperatives. Insurance companies with over RMB50 million and CD terms longer than three years use interest rates determined by agreement between the company and the customer.
In September 2000, three reforms on foreign currency interest rates were implemented. Under these reforms, foreign currency lending rates are decided independently by the financial institution; foreign currency small-deposit rates are first discussed by the banking union and then approved by the PBOC; and for deposits of more than RMB3 million in foreign currency, the interest rate is determined by agreement between the commercial bank and the customer. On July 1, 2003, we also loosened controls over rates for small-deposit accounts in three currencies: the pound, Swiss franc and Canadian dollar. Currently, only the small-deposit rates for the U.S. dollar, euro, Hong Kong dollar and yen are regulated by the PBOC.
In recent years, county financial institutions, especially rural credit cooperatives, have been the main focus of China's market-based interest rate reforms. In 1998, we increased the upper limit for lending rates at rural credit cooperatives from 40 percent to 50 percent; in 1999, lending rates at the county financial institutions were allowed to float up to 30 percent. At the beginning of 2002, eight county and rural credit cooperatives experimented with market-based interest rate reform; the lending rate float band was widened from 50 percent to 100 percent, the deposit rate float was increased up to 50 percent. In September , the reform trial was expanded to every province other than municipalities directly under the central government. Wenzhou City also has implemented interest rate reform.
As stated in the "Trial Act Regarding the Deepening of Reforms at Rural Credit Cooperatives" issued in June 2003, the experimental rural credit cooperatives "in the districts with active private lending and borrowing are allowed to use a flexible interest rate policy in which rates can float around one to two times the basic lending rate. The lending rate is not allowed to increase for small loans to farmers, but may float up for high-risk loans and float down for rural people in disaster areas."
The experience of these rural credit cooperatives will be reviewed and assessed continuously and be expanded under some conditions.
Rolnick: The widening income gap, especially between China's cities and countryside, has become an increasing concern for Chinese policymakers, with Premier Wen Jiabao expressing his desire to relieve the hardships faced by farmers and others in rural areas. This concern arises in part because urban incomes have grown faster than those in the countryside, and per capita income is three times higher in cities. This has in turn led to increased rural-to-urban migration.
Will the People's Bank of China play a role in addressing these concerns? Are the rural lending experiments you've just described expected to help conditions in the countryside?
Xie: In recent years, the People's Bank of China has played a vital role in coordinating central government policy to support agricultural development and the rural economy and to increase farmers' income.
First, a series of credit policies has been introduced to increase credit and lending to the agricultural sector, to improve rural financial services, to boost farmers' income and to comprehensively manage the rural credit project. Since 1998, the central bank had published successive issues of "Instructions about the Current Rural Credit Project" and related documents to request the financial system to accomplish the following tasks: Guarantee credit sources to agriculture; increase credit inputs toward agriculture infrastructure, technology improvement and purchase of agricultural byproducts; strengthen the management of loans to help the poor; improve rural financial services; propose that the rural finance organizations follow a system that respects geographic regions while permitting flexibility in the provision of credit; expand the scope of credit in accord with the reasonable needs of farm households; better serve farmers; support agricultural development, farm product processing and agricultural industry management; and simultaneously emphasize that rural credit cooperatives may provide credit loans, as well as rural housing loans, education loans and consumption loans.
Second, extend small credit loans to farmers and increase credit inputs to farmers and agricultural production. Third, increase investment in infrastructure for agriculture.
The PBOC also uses refinancing to improve credit for the agricultural sector. From 1997 to December 2002, the total amount of refinancing was RMB123.6 billion. This refinancing focused on the agricultural provinces, the midwest region and the regions hit by natural disasters to effectively relieve their capital needs. This also played an important role in supporting rural credit cooperatives to grant small credit loans and joint loans for farm households. In the past few years, 89 percent of rural credit cooperatives started small credit loans, 49 percent started joint credit loans and 25 percent of farmers received either small credit or joint credit loans.
Furthermore, the PBOC grants discounted development loans to poor areas and to farmers. From 2000 to 2002, the Agricultural Bank of China granted loans totaling RMB76.7 billion to help farmers prosper, to support the industrialization of agricultural enterprises and to bolster infrastructure construction, educational projects and zoological tourism projects. These loans have encouraged additional investment of RMB174.1 billion and have lifted 4 million people out of poverty. At the end of first quarter 2003, the total outstanding loan balance of the Agricultural Bank of China was RMB92.9 billion, of which RMB47.9 billion was in discount loans.
The rural credit cooperative is an important part of the financial system in China. It is the main resource for agriculture, the rural economy and farmers. Currently, the reform of market interest rates in rural credit cooperatives has increased the float band for both deposit and loan interest rates. This helps rural credit cooperatives attract deposits, organize capital, prevent rural capital from flowing to the cities, utilize capital efficiently, enhance development capacity and finally, increase credit to agriculture and the rural economy and improve the income levels of farmers.
For the urban poor, the People's Bank, together with related ministries, has devised another initiative: "About Measures of Supervising Small Credit Loans to Persons who are Laid Off or Unemployed" to expand small credit loans and support reemployment.
Rolnick: China's consumer price index has fallen in four of the last five years, dropping 0.8 percent in 2002, for a cumulative five-year CPI drop of 3.1 percent. Are you concerned about this persistent deflationary trend? How do you explain such deflation in light of the fact that your economy has grown so rapidly and your money supply has also expanded at double-digit rates in recent years?
Xie: This question includes three aspects: how to understand deflation, how to understand Chinese deflation and the relationship between money and economic growth.
First, how to understand and define deflation. Usually deflation is defined as a sustained decrease in the price level. We need to pay attention to three points in understanding deflation. First, the choice of price indices. The major price indices are the consumer price index (CPI), wholesale price index (WPI), and gross domestic product (GDP) deflator. It is commonly believed that the GDP deflator is the best index to determine whether deflation occurs. But China doesn't compile data to calculate the GDP deflator. Since the CPI is a better measurement of change in welfare due to changes in the price level, China uses the CPI as the major indicator to measure deflation. Second is the scope of deflation. Western scholars usually consider inflation less than 1 percent as deflation since governments have a tendency of overestimating inflation by 1 percent. Third is the duration of deflation. It is commonly believed that the criterion for deflation is a sustained drop in the price level over two quarters.
According to the above criterion, China is experiencing mild deflation since the change of CPI in China has been between -1 percent and 1 percent since 1998. It is well known that since 1998 the Chinese government has paid a great deal of attention to deflation, fought deflation through proactive fiscal policy and sound monetary policy and achieved marked results. In the first half of 2003, credit and loans increased greatly and money supply also grew rapidly. As a result, we not only need to fight deflation, but also need to prevent inflation, maintain a stable currency and provide a good monetary environment for economic development.
Next, how to understand the coexistence of rapid growth of China economy and deflation. After China successfully achieved a "soft landing" in 1996, the annual growth rate has declined compared to past years but remains between 7 percent and 8.2 percent. In a global setting where most countries are facing deflation and depression, China's economy still grows rapidly and has a promising future. But given its exposure to the international economy, China cannot avoid worldwide deflation. Thus high growth rates and deflation coexist. Rapid growth in aggregate demand is the precondition of high growth in the economy. But the existence of deflation means insufficient or declining demand. The key to understanding this phenomenon is to understand total demand. In China, proactive fiscal policy through investment and exports generates rapid growth, but insufficient consumer demand results in deflation.
Our economic growth comes mainly from the rapid growth in investment and exports. In the first half of 2002, total fixed investment was RMB1.4462 trillion, which is a 21.5 percent increase over the same period in 2001; the growth rate is 6.4 percent higher than same period of 2001. And public and private investments both climbed: State-owned investment in the first half of 2002 increased by 24.4 percent over the same period of 2001; the growth rate was higher by 6.5 percent. Urban and rural collective and individual investment increased by 17.8 percent over the same period of 2001, a trend rarely seen in recent years. As for exports, in the first half of 2002, total exports were US$142.1 billion, which was a 14.1 percent increase over the same period of 2001; the growth rate increased by 5.4 percent.
In the first half of 2003, investments reached a new high. The accumulated total investments accomplished were RMB1.9348 trillion, a 31 percent increase over the same period last year; the growth rate was 9.6 percent higher. Public investment was RMB1.5073 trillion, a 32.8 percent increase over first half 2002, and private investment was RMB427.5 billion, a 25.5 percent increase. Exports totaled US$190.3 billion in the first half of 2003, a 34 percent increase.
The growth rate of consumption has slowed down. In the first half of 2002, aggregate retail sales of consumption goods was RMB1.9959 trillion, an 8.6 percent increase in nominal terms over the same period of 2001. In inflation-adjusted prices, the growth rate was 9.4 percent, 0.6 percent lower than the previous year. The slowdown of consumption is mainly because income and expenditure expectations didn't improve. The high pressure of unemployment and the expectation of higher future expenses, especially due to the poor social security system, led to more saving, less consumption and a fall in propensity to consume. Also, worldwide and domestic agricultural prices have been falling in recent years. Farmers have incurred losses of RMB350 billion, and the growth rate of farm income per farmer has decreased continuously for four years. In 2002, the growth rate was 4 percent. This has led to sluggish rural consumer demand. In addition, the extensive spread of SARS in the first half of this year also influenced consumer demand, though the overall influence has been small.
Lastly, let's discuss the coexistence of high growth rate in money supply and deflation: Traditional quantity theory argues that the growth rate of money supply equals the sum of economic growth rate and inflation. When the money supply growth rate is higher than the economic growth rate, the difference is the inflation rate. But in recent years in China, the growth rate of money supply has remained around 14 percent to 15 percent, which is higher than the economic growth rate of 7 percent. In the first half of this year, there is deflation even though the money supply growth rate is 12 percent higher than the economic growth rate.
We think the coexistence of high money supply growth rate and deflation is the result of multiple factors:
Rolnick: For many years, the Chinese government has financed its expenditures through deficit spending. The budget presented to the National People's Congress in March 2003 projected a 3.2 percent increase in the deficit, which will rise to US$38.6 billion, about 3 percent of GDP. That is a record deficit for China, I believe, though the 2003 rise is modest compared with last year's double-digit increase.
Are you concerned that such deficit spending might be unsustainable? Is the government borrowing too much or can it afford to continue building debt?
Xie: In 1998, China started to carry out a proactive fiscal policy characterized by an increase in long-term construction government bonds and investment in infrastructure and technology improvement. Over the past five years, this proactive fiscal policy has achieved clear results in promoting stable economic growth, speeding up adjustment in the economic structure, improving the social security system, and so on.
But over time, the negative effects of proactive fiscal policy have emerged. In recent years, the deficit ratio and debt ratio have increased markedly: From 1998 to 2002, the deficit-to-GDP ratio increased from 1.2 percent to 3 percent and the debt-to-GDP ratio increased from 11 percent to 18 percent. Furthermore, continued short-term countercyclical practices will increase the government's direct intervention in the economy, contrary to the objectives of market-based reform. All these questions influence the sustainability of proactive fiscal policy and the ability to implement agreed-upon macro adjustment objectives.
The necessity of maintaining proactive fiscal policy in recent years
The active fiscal policy was designed as a countermeasure to the slowdown of the economy after the Asian financial crisis. The objectives are to increase the economic growth rate and to provide a good environment for economic reforms. Whether to continue this policy depends on the following conditions: first, an improved international environment and rapid growth in external demand; second, the systematic recovery and prosperity of private investment and the formation of independent growth mechanisms for domestic investment and consumer demand; and third, the ratios of deficit and debt over GDP relative to warning levels.
Looking at our current economic circumstances, it appears that the international economy is recovering slowly but the outlook is still uncertain. The formation of independent growth mechanisms of domestic investment and consumer demand has been very slow and is currently unable to replace government investment. Based on the economic situation in 2002, external factors are apparently strong for economic growth, depending mainly on rapid growth in investment and exports. The fast growth of investment originates from government investment, while growth in exports will be difficult in the future.
Moreover, required fiscal expenditures necessitate that we maintain some level of debt: huge pressure on central government finances from economic structural adjustments (the debt of state-owned enterprises and bad loans, increase in social security spending); infrastructure investment in projects to support development in western China; peak periods of repaying debt and interest, etc. Currently, the ratio of outstanding debt over GDP hasn't reached the international warning line and the ratio of deficit over GDP is closing in on the warning line but still leaves some room. Therefore, proactive fiscal policy will continue to be implemented.
Feasibility of issuing debt
The fiscal deficit and scale of debt in China are both still within internationally accepted guidelines. The debt ratios for 1998-2002 are 11 percent, 12.7 percent, 14.6 percent, 16.3 percent and 18 percent, respectively, and obviously below the ratios of most developed countries. The deficit ratio in 2002 reached 3 percent. But when compared to the 1992-1995 recession period in the developed countries, the deficit ratio in China is not high; when compared to the Eastern European transition economies, it is low; and by overall international standards, it is about average, or perhaps at a somewhat low level.
The overall scale of government debt in China is small and reasonable, with quite a strong ability to repay debt and with no risk of default. Since 1998, when the proactive fiscal policy was begun, the risk of government debt has increased to some extent, but it is still under control. Moreover, the major part of fiscal risk in China is from bad assets in state-owned banks, gaps in the social insurance funds and the implicit retirement debt of state-owned enterprises; [just] a small part is from government debt. The overall debt risk to the Chinese financial system is low. A suitable increase in national debt will not impose too much additional burden.
In the medium and long run, there is still some room for issuing debt in China and there are solid funding resources. First, the savings rate in China is quite high, around 40 percent. The banks have sufficient capital with a large margin between lending and deposit interest rates and a low overall interest rate level.
Of course, while continuing to implement proactive fiscal policy, we must strengthen risk awareness and risk prevention mechanisms; be aware of the overall situation at the ground level; set reasonable limits for deficit and debt issuance; properly adjust debt structure; pay attention to the linkages between and coordination of countercyclical short-term policies and medium- to long-run policies in order to sustain growth and deepen reform; try to find time and opportunities to solve deep systemic and structural problems; provide a good environment for positive economic and financial cycles; and prepare for a new round of rapid economic growth.
Rolnick: Observers throughout the world have been surprised and impressed by China's rapid economic growth, its remarkable transformation from central planning to increased reliance on markets, its growing openness to international trade and its quickly developing infrastructure. Is there anything that would stand in the way of the Chinese economy continuing to grow at this robust rate, or do you foresee sustained economic expansion in coming decades?
Xie: In recent years, the Chinese economy has maintained a high growth rate. Since 1998, the annual GDP growth rate has been over 7 percent. And in 2003, the economy continues to grow rapidly. In the first half of this year, GDP, fixed investment, consumption and net exports grew at 8.2 percent, 31.1 percent, 8 percent and 39 percent, respectively. The growth rates of fixed investment and net export were the highest seen in recent years.
The main reasons for China's rapid growth are the following:
There also exist several problems in China's economy. First, employment pressure is high due to the contradiction between the huge population and increasing labor productivity. Second, [personal] income grows slowly, especially in rural areas, and this is incompatible with the nation's high GDP growth rate. Third, the economy is still experiencing insufficient demand—aggregate supply is greater than aggregate demand. In addition, in some areas there still exist unwise investments and redundant construction of low efficiency. And last, the growth rate of the consumer price index has just become positive (-0.6 percent in 2002 and 0.6 percent in the first half of 2003).
Over the next 10 years, China's economy will continue to grow rapidly; the forecasted average annual growth rate of GDP is over 7 percent. The reasons are as follows: First, the infrastructure to sustain Chinese economic growth is becoming more solid, especially in transportation, communication, irrigation works and energy. Also there has been progress in industrial techniques, and science and technology innovation. Second, China has big markets and great potential. Third, with continuing inflow of foreign capital, China is becoming the international focus for foreign investment. This will speed up structural adjustment in industry and the renewal and upgrading of products. Fourth, with the market system established, economic rigor and competitiveness are increasing over time.
Rolnick: As you noted, China's national savings rate appears to be around 40 percent of GDP—very high relative to most countries. Why is China's savings rate so high? Do you expect it to come down in the near future?
Xie: China's national savings rate has been high for many years and savings grow rapidly. Currently the national savings rate is about 38 percent to 40 percent of GDP. The balance held on deposit in financial institutions reached RMB10 trillion in June 2003. The growth rate is above 18 percent.
There are four major reasons for the rapid growth of China's national savings. First and most basic is the steadily increasing national income. In recent years, the annual growth rate of GDP has been above 7 percent. Correspondingly, the national income also grows quite steadily: Urban income grew at 9.2 percent in 2002 and 13.4 percent in 2003. Though slower than urban income, rural income is also growing steadily.
Second, uncertainty about expected income and expenditures has increased the propensity to save. Since China is transforming its systems of income distribution, consumption, social security, prices, education, finances, and so on, people must now begin to pay for many items that used to be government welfare benefits. Therefore, many people are reducing their current consumption and saving part of their income at their bank to provide for future expenses.
Third, China has a long tradition of thrift. People usually purchase big-ticket items, such as houses, cars and so on, through self-financing, and this requires a long process of saving.
Fourth, limited opportunities for other types of personal investment lead to the concentration of financial assets in savings accounts. The stock market and other investments are risky. Particularly in recent years, declines in the stock market have forced people to invest conservatively. Other new investment tools have not become accepted by or familiar to the public.
Rapid growth in national savings has bolstered the high growth rate of China's economy. With rapid growth in savings, the growth rate of investment is also sustained at a high level. In terms of overall trends, high national saving is just a normal phenomenon in China's process of transformation. In the future, national savings will continue to grow rapidly.
But there are also a few problems with the high savings rate. For example, in the financial structure, the proportion of loans financed indirectly is too high and the proportion financed directly, through stock and debt, for instance, is too low. This greatly increases the risk and cost of bank loans and credit. Another problem: The fall in propensity to consume dampens the effect of expansionary investment to some extent and also affects the growth of consumer demand. We therefore need to pay attention to these problems and consider measures to raise efficiency in using savings resources and to create more financing channels.
More specifically: (1) implement the social security system as soon as possible to enhance the public's expectations; (2) expand current consumption, reorganize markets and modernize products and promote innovation as soon as possible; (3) broaden personal investment opportunities, encourage financial innovation and provide more profitable investment channels and products; (4) through faster development of direct financing, speed the transition from savings deposits as the source of financing to stocks, debt, funds and life insurance.
From the point of view of the PBOC, the contradiction between the current high national savings rate and the difficulties faced by farmers and small or medium-sized businesses in getting loans is significant. This is a major issue that the financial system faces; it must be studied seriously and solved. Since direct financing channels are impeded, medium- and small-scale enterprise financing mainly depends on bank loans. On the one hand, these firms have only a small capital base, but have high debt. Banks lack incentive to make loans to them due to risk considerations. On the other hand, savings deposits in the banks are huge. To lend out their capital, banks have to lower requirements on loans and thus they create new risks.
Hence, we must adopt comprehensive measures to solve the efficiency problem in using savings deposit resources. More specifically: (1) study how to induce banks to sell direct financing products (for example, stock investment products) more actively; (2) learn from the developed economies how to develop policies to encourage direct financing and make investors feel that direct financing is better than savings deposits in some respects; (3) in supervision policy, we must strictly execute the capital adequacy requirements established by the Basel Accord. Absorbing deposits and making loans will increase the amount of risky assets in banks and require banks to have more capital. When banks don't have sufficient capital assets, they will consider using other financial products in which borrowers assume the risk (in particular, direct financing products) instead of deposits. And (4) transform financial products (including credit-derived products) into debt products, including financial debt, that are accepted by the market.
Rolnick: Thank you very much.
Editor's note: We are grateful to Yan Bai and Jing Zhang, economics graduate students at the University of Minnesota, for their careful translation of this interview from Chinese.
* The June 2003 debt ratio of 22.19 percent is based on a different asset classification system than the end of 2002 debt ratio of 21.41 percent mentioned in the previous paragraph.
More about Ping Xie
Mr. Xie was born in the port city of Wenzhou in Zhejiang Province, on China's east coast. he received his master's degree in economics from China's Xinan University of Finance and Economics in 1984 and his doctorate in economics from Renmin University in 1988.
From 1985 to 1987, he worked as deputy division chief and then chief in the Planning Department, Interest Rate Department and Policy Research Department of the PBOC. From 1994 to 1997 he was deputy director of the Policy Research Department and director of the Non-bank Financial Institutions Department. He became governor of of the Hunan Branch of the PBOC in November 1997, but several months later was appointed as director-general of the PBOC's Research Department and made a PBOC Senior Research Fellow.
Xie's economic research has won a number of prestigious academic awards in China, including the Sun YeFang Economic Science award and the Society for Finance and Banking excellence award. He is chief editor of the Journal of Financial Research, senior research fellow of the Financial Study Centre of the China Academy of Social Science, and professor at Xinan University of Finance and Economics, Nan Kai University and Renmin University.