Loren Brandt - Professor of Finance, University of Toronto
Xiaodong Zhu - Professor of Finance, University of Toronto
Published December 1, 2003 | December 2003 issue
Editor's note: The following article, which analyzes China's economy through 1999, is excerpted from East Asia in Transition: Economic and Security Challenges* and is reprinted with the permission of University of Toronto Press.
Since 1994, China has experienced a prolonged period
of declining inflation during which growth has also fallen sharply.
Over much of the last three years prices have actually declined. The
simultaneous reduction in growth and inflation has led many to attribute
the macroeconomic problems China is now facing to the condition of
weak aggregate demand. Not unexpectedly, the Chinese government has
cut interest rates several times and has vigorously pursued an expansionary
Keynesian spending policy in hopes of stimulating aggregate demand.
However, these measures have had only limited effects. Prices in most
sectors continue to fall, and output growth remains sluggish.1
The persistent decline in economic activity in the
last several years is in stark contrast to a highly cyclical pattern
of growth between 1978 and 1994, during which high inflation
rather than deflation was the main concern of the government.
In this [article], we provide an explanation for the behaviour of output growth and price-level changes in China that can account for both the cyclical pattern between 1980 and 1994 and the secular decline in recent years. Our analysis suggests that the reason for the declining growth is not weak aggregate demand. Thus, traditional aggregate demand policies have not and will not be very helpful. Rather, we contend that the lacklustre growth is a result of financial disintermediation, which has caused slower growth of investment in the non-state sector. The financial disintermediation, moreover, is a result of the government's financial repression policy over the last two decades and its recent effort in centralizing the financial system. For the economy to grow more rapidly the Chinese government needs to eliminate financial repression and allow the entry of new, privately owned, locally based financial institutions.
Central to our explanation are the government's commitment to the state sector and the behaviour in the financial system. Before 1994, the central government maintained a strong commitment to employment growth in the state sector. Severe fiscal constraints forced the central government to look to the financial sector as a source of revenue for supporting the state sector. While there was some financial decentralization, the central government continued to impose control on the financial system's credit allocation. During this period, more than 80 percent of the banking system's credits were directed to the state sector, and lending to the non-state sector can best be described as a process of intermediation by diversion. Because of higher average returns in the more productive non-state sector, whenever possible, state-owned banks (SOBs) diverted credits intended for the state sector to the non-state sector. While this increased output growth, it also forced the government to rely more heavily on money creation to finance the transfers to the state sector, which led to high inflation. The cyclical pattern of growth and inflation up through 1994 was the result of the government's inability to control the state banks' credit diversion in the face of financial decentralization and the periodic need to resort to recentralization and administrative control of credit allocation to reduce inflation.
The cyclical growth process, however, was inefficient and unsustainable. The government's use of the financial system to support the state sector resulted in soft budget constraints for both the SOBs and for state-owned enterprises (SOEs) and was the main reason for their deteriorating financial performance. As the productivity gap between the state and the non-state sector widened, there was a steady increase in the size of the transfers required to support SOEs. Mounting losses of the SOEs led to a rapid increase in non-performing loans in the SOBs, putting the whole financial system at risk. There is also a limit to how much revenue can be raised through money creation, and the rapidly rising inflation in 1993-94 indicated that the required transfers were pushing this limit.
It was largely because of these difficulties that beginning in 1994 we see an overall tightening in policy towards the SOBs and SOEs. The People's Bank of China (PBOC), China's central bank, centralized and significantly reduced its lending to the SOBs, and the government began an effort to commercialize the SOBs by putting them in the position of assuming increasing responsibility for their losses and bad loans. The government was able to do so by reducing its long-standing commitment to the state sector. It privatized some small SOEs, allowed large SOEs to lay off workers, and shifted much of the costs of these lay-offs to local governments. As an integral part of the overall tightening policy, the government also lowered the money supply's growth rate significantly, leading to the prolonged decline in inflation.
While these measures have had a desired consequence of hardening the budget constraints of the SOBs and the SOEs, they have also had an important unintended consequence: disintermediation in the financial system and a decline in lending to the non-state sector. This has occurred for several reasons. First, the SOBs have become highly risk averse because of their bad-debt problem and their increased responsibility for their losses. Second, banks are handicapped in identifying good projects due to a lack of information and human capital. Both of these factors have contributed to a voluntary tightening of credit by the SOBs. Third, the financial system has become more centralized in recent years, making the financial institutions more biased against lending to small and medium enterprises (SMEs) in the non-state sector. Fourth, as part of its financial repression policy, the central government has clamped down on and closed many informal financial institutions such as rural credit cooperative foundations (RCFs) that were not directly under its control. This action has denied the non-state sector a valuable source of financial intermediation. Since 1994, the growth of credit to the non-state sector has declined sharply. It is this decline in credit growth to the non-state sector that is largely responsible for the economy's continued decline in output growth the last several years.
There are several policy implications regarding China's financial system that we can draw from our analysis. First, relaxing constraints on the financial institutions through new infusions of funds from the PBOC, as was often done in the past, is not the solution. Second, major policy initiatives, including the re-capitalization and commercialization of the SOBs, the much-discussed entry of foreign banks with WTO, and opening the capital markets to non-state firms, while very important for large firms, will only have limited effects on overall growth prospects. Third, it will not be efficient simply to target SMEs for increased lending by existing financial institutions or by any newly established centralized financial institutions. To solve China's economic woes in both the short and long term the government should adopt a more radical strategy of reform for the financial system: allowing the entry of new, privately owned, locally based financial institutions that can provide efficient financial intermediations for the SMEs. ...
Money supply and inflation
China's current deflation follows in the wake of a steady decline in the rate of inflation. After peaking late in 1994, inflation fell for three years until deflation set in beginning in 1998. Inflation is usually a monetary phenomenon, and in China this is also the case.
Over the last 20 years, there is a very strong relationship between the behaviour of M0, the narrowest measure of the money supply, and the changes in the retail price index in China. ... (See Figure 1.) The declining inflation rate is a direct result of the sharp reductions in the increase in money supply since 1994.
Figure 1: Money Creation and Inflation
The Asian financial crisis and deflation
While tight monetary policy can account for the generally low inflation rate experienced in the last several years, it cannot fully account for the deflation that started in 1998. Some have suggested that the deflation is a result of excess capacity. ...
A more plausible explanation ... is that it is a response to the competitive pressure created by the devaluation of several other Asian currencies. Since China effectively maintains a fixed exchange rate with the U.S. dollar, the devaluation of the Asian currencies put downward pressure on the prices of tradable goods. ...
Thus, deflation may simply be a result of market
adjustment of the real exchange rate in response to external shocks under a fixed exchange-rate regime, which may have actually helped to dampen the impact of the Asian financial crisis on China's exports and overall growth. What, then, caused the growth slowdown?
Credit allocation, non-state sector investment, and growth
Over the last two decades, China's non-state sector, which includes collective and private enterprises, has been the main source of output growth. In 1978, when the economic reform started, only 22 percent of industrial output was produced in the non-state sector. Since then, the non-state sector's contribution has increased steadily, and by 1998 accounted for 72 percent of industrial output. Central to growth in the non-state sector, and thus to overall growth, is the level of investment in the sector. Figure 2 shows the strong positive relationship between GNP growth and the growth rate of non-state sector investment. ...
Figure 2: Non-state Investment and Growth
Investment in the non-state sector, however, is constrained by the availability of credit. ... Over the last couple of years, ... [bank credit and foreign investment] have declined significantly, leading to a slowdown in investment growth in the non-state sector and, therefore, slower output growth for the whole economy. ...
Money supply and credit to the non-state sector have consistently been the two key factors determining price-level changes and growth throughout the reform period. The recent decline in inflation and output growth is a direct result of a tightening of money supply and a decline in credit growth, a problem that has been confounded by the Asian financial crisis. To understand China's current macroeconomic problem, then, we need to analyse how monetary policy and credit allocation by the financial institutions are determined in China. The key to this analysis is the behaviour in the financial sector.
Before the reforms, China had a mono-bank system in which the PBOC simply served as a cashier of the government. Household savings in the form of deposits were minimal, amounting to only about 5 percent of GNP, and no real intermediation went on. There were also no capital markets. Allocation of fixed investment and working capital to firms was determined administratively by the overall economic plan. ...
In the early 1980s, the banking system was restructured. The PBOC became the central bank, and its commercial divisions were converted into four state-owned specialized banks. Grants were gradually converted into loans that were financed by the rapid build-up in household deposits in China's financial institutions.2 However, the government continued a policy of financial repression. The overriding objective of the state banking system has been to provide resources for the state sector, and the development of new financial intermediaries has been constrained. Capital markets have faced similar obstacles and been largely used to mobilize resources for fiscal purposes (through the development of a government debt market), or for financing restructuring of SOEs. ...
Even with financial repression, over much of this period we do observe some decentralization within the state-controlled financial system. SOBs were given some discretion in their lending decisions through the use of an indicative credit plan. In addition to the rural credit cooperatives (RCCs), other non-bank financial institutions were also established, including the urban credit cooperatives (UCCs) and trust and investment companies (TICs). ...
China also has an informal financial sector that fell almost entirely outside of the purview of state control. ...
The seemingly paradoxical policy of financial repression and partial financial decentralization reflects a trade-off the government faces between its commitment to support the state sector and the need to promote the growth of the whole economy. In the next section we show how the government's choices in trading off these two factors resulted in growth and inflation cycles before 1994.
Before 1994, China's monetary policy can be characterized as a stop-go policy: it tightened whenever inflation accelerated, but loosened again once inflation was under control. Correspondingly, growth and inflation were highly cyclical. (See Figure 3.) At the root of these dynamics were the government's commitment to the state sector and the behaviour of credit allocation between the state and non-state sectors.
Figure 3: Growth and Inflation
Ever since the economic reforms started in 1978, productivity and output growth in the state sector have been significantly lower than that in the non-state sector. Up through 1993, however, the central government maintained a strong commitment to employment in the state sector that enabled it to grow on a par with that achieved in the non-state sector. Because the state sector's share of output was declining, maintaining this commitment required a steady flow of transfers to the state sector. Facing severe fiscal constraints, the central government financed the transfers mainly with cheap credit from the state banking system and money creation. To ensure that a large portion of total bank credit was directed to the state sector, the government used the credit plan as its principal instrument to control the banking system's credit allocation.
In most years, the credit plan was used as an indicative plan under which SOBs were given some discretion in lending activity to enable them to use their superior information to allocate credit more efficiently. They used this discretion, however, to divert bank resources intended for the state sector under the plan to the non-state sector, in which returns were higher. ...
The diversion of credit to the non-state sector contributed to an increase in investment in the more productive non-state sector [which] ... had a positive effect on growth in the economy. This behaviour, however, left the banks without the resources needed to fund the commitments for fixed and working capital investment outlined in the plan that were essential to supporting employment growth in the state sector. The gap in funding requirements was filled by lending from the PBOC to the SOBs, which contributed to money-supply increases and inflation.
The threat of hyperinflation ultimately required the government to reassert full control over credit allocation in the economy. ... Inflation fell with the reduction in PBOC lending. The use of the administrative plan, however, came at the cost of lower economic growth as a lower percentage of resources made their way to the more productive non-state sector, and all discretion in credit allocation was eliminated. The high costs associated with these administrative measures explain the government's delay in their implementation, and thus, the cycles.
By 1994, China had experienced three episodes of high inflation. The macroeconomic problems caused by the inefficiency of the state sector steadily worsened. Our estimates for the period between 1986 and 1993 suggest that as the productivity gap between the state and non-state sectors widened, there was a steady increase in the size of the transfers required to support SOEs in industry, a majority of which were financed by loans from SOBs. Since many of these loans were not being repaid, a bad debt problem developed, which put the entire financial system at risk. Estimates differ, but by 1993 total non-performing loans were as much as 25 percent of GDP.
The deterioration of the SOBs' loan portfolio put strong pressure on the central bank to use money creation to finance the transfers. There is a limit to how much revenue can be raised through money creation. As the gap between the state and the non-state sectors widened, there were signs indicating that the required transfers were nearing this limit. Symptomatic of these growing pressures, in each of the three cycles the peak inflation rate was progressively higher, pushing nearly 50 percent on an annual basis during the last of the cycles.
The recurring inflation and deteriorating performance of the state-owned enterprises and banks made the government realize that the stop-go policy was not sustainable and that it could not maintain its support to the state sector indefinitely without running the risk of hyperinflation and a collapse of the banking system. It is against this background that the government in 1994 finally started to tackle directly the fundamental problem of the economy: inefficiency of the state-owned enterprises and banks caused by soft budget constraints.
Several steps were taken in 1994 to harden the budget constraints.
First and foremost, the government reduced its long-standing commitment to support employment growth in the state sector, which was the main reason for the soft budget constraints. The government started a policy of privatizing small SOEs at the county level and downsizing SOEs at the city level. Second, the PBOC centralized and reduced its loans to SOBs, which had been an important source of funds for loans to the SOEs. Third, the government began an effort to commercialize the SOBs by putting them in the position of assuming increasing responsibility for their losses and bad debts.
The result of these policy changes has been impressive. After growing at roughly the same rate as the rest of the economy for the period 1979-94, employment in the state sector started to decline significantly in 1995 (see table). Between 1995 and 1999, employment in the state sector was reduced by 26.9 million, while employment in the non-state sector increased by 50 million. The reduction of state-sector employment was most pronounced in industry. During this four-year period, the industrial SOEs let go 45 percent of their workers (or 19.9 million).
Policy Regime Shifts in 1994
The PBOC was fairly successful as well in tightening its lending to SOBs. After averaging almost 17 percent before 1994, the growth rate of PBOC loans to SOBs never exceeded 10 percent after 1994. Between 1996 and 1999, PBOC lending to SOBs actually declined in absolute terms. This tightening of the PBOC lending is the main reason for the sharp decline in money-supply growth since 1994.
Changing the behaviour of the SOBs turned out to be the hardest task. However, there are signs that the government's effort to tighten the SOBs' budget constraint is finally taking effect. After averaging 21 percent for the period 1980-97, the SOBs' credit growth rate declined to 15.4 percent in 1998 and 7.7 percent in 1999. It also appears that the SOBs have become more discriminating in their lending decisions. The percentage of SOB working-capital loans that went to the SOEs declined from 91 percent in 1996 to below 67 percent in 1997-98 and to only 7.8 percent in 1999. Since cheap working-capital loans were a major component of government transfers to the SOEs, the sharp reduction in working-capital loans to SOEs represents a significant hardening of the SOEs' budget constraint.
These policy changes have made the economy more efficient by reducing resource flows into the inefficient state sector. First, they forced the downsizing and even closing down of many money-losing SOEs formerly supported by working-capital loans. Second, they reduced inefficient and often wasteful investment by SOEs. Between 1995 and 1999, the real growth rate of fixed investment by SOEs in industry averaged only 0.2 percent, compared to 11.8 percent for the period 1982-94.
The reduction in growth of credit to the state sector does not imply that the resource flow into the non-state sector has increased. As we documented in the second section, the real growth rate of investment in the non-state sector has also declined sharply, mainly due to the reduction in growth of credit to the sector. Given the government's effort to commercialize banks, one might have expected that SOBs would lend more to the non-state sector. After all, rates of return are higher in the non-state sector, and in 1998 the central government eliminated credit quotas for the SOBs. Why has the credit to the non-state sector continued to be so tight?
There are several factors that have contributed to the current problem of financial disintermediation. First, the SOBs have become highly risk-averse because of the bad-debt problem and their increased responsibility for losses. Second, the banks are handicapped in identifying good projects due to a lack of information and human capital. Third, the financial system has become more centralized in recent years, making the financial institutions more biased against lending to the SMEs in the non-state sector. Fourth, the government has continued to clamp down on informal financial institutions and markets, severely limiting their role in financial intermediation. Reflecting the effect of these factors, we see a steady decline of the loan-deposit ratio for all financial institutions. Since 1995, the increase in loans by all financial institutions has only been 60 percent of the increase in deposits.
These developments are ultimately products of the financial repression policy pursued by the government. ...
What can the government do to return the economy to a higher but sustainable growth regime? ... [F]iscal and monetary policy have not been effective in promoting growth in recent years and ... they will not be effective in the near future.
Over the last couple of years, the central government has relied on deficit-financed public investment to stimulate growth. In 1998, for example, the government ran a deficit of 92.2 billion RMB, or 9.3 percent of total government expenditure. In 1999, the deficit almost doubled to 175.9 billion RMB, or 2.1 percent of GNP. The impact, however, has been very limited. ... [T]he main reason for sluggish growth in China is not a lack of demand, but rather a lack of intermediaries that can channel savings into efficient investment projects. Fiscal policy does not help in solving this problem. Instead, it crowds out resources that can potentially be used for investment in the non-state sector.
Fiscal policy may have played a positive role in redistribution. Regional inequality has increased sharply in recent years. ... From a social-welfare point of view, using fiscal policy to redistribute may be desirable, but its effect on the economy should not be mistaken: it redistributes income with little and possibly negative impact on growth.
The central government has also tried to use monetary policy to stimulate growth. Before 1994, this was mainly done by increasing PBOC lending to the SOBs and relaxing restrictions on credit allocation by the SOBs, which allowed intermediation by diversion. As we discussed in previous sections, while this policy helped stimulate growth it was inflationary and unsustainable. A return to such policy would undermine the government's effort in hardening the budget constraints on both the SOBs and the SOEs, contribute to further increases in bad debt, generate high inflation, and put the financial system and the whole economy at grave risk.
Given that relaxing PBOC lending is not a viable option, the government tried in recent years to use the interest rate as an instrument for its operation of monetary policy. The central government has cut interest rates several times in hope of stimulating investment demand, but investment remains sluggish. There are two reasons for the ineffectiveness of the interest rate policy. First, most SOEs are highly inefficient and have problems finding investment projects that provide positive returns. Even if the interest rate were zero, the SOEs would find their projects to have negative net present values. This lack of good projects and the recent hardening of budget constraints have reduced the SOEs' demand for investment significantly. Second, even though there are highly profitable projects in the non-state sector that would have positive net present values at a market-clearing interest rate, they are not financed by the banks because of the latter's inability to distinguish between good and bad projects. This problem is due to the SOBs' lack of information and human capital, and lowering interest rates will not help much.
Our analysis shows that the main problem China is now facing is financial disintermediation: the lack of intermediaries that can direct savings to efficient investment in the non-state sector. How can China overcome this problem? Will the financial reforms that are being carried out by the government help? What kind of a financial system does China need? Drawing on the recent literature on financial system design and based on our analysis in previous sections, we provide here a discussion on the specific measures that China needs to take to transform the financial system into one that can meet China's development needs.
The financial system for China
China is at an early stage of economic development. It does not have a well-functioning legal system, financial information about firms is limited, accounting standards are weak, and non-state SMEs are the major source of economic growth. All these conditions suggest that in the short to medium term financial intermediaries should play a more important role than capital markets in China's economic development. However, China's current financial system is dominated by the SOBs. Our earlier discussion indicates that the SOBs have not been effective as financial intermediaries. Some of the problems that inhibit effective intermediation by the SOBs, such as the bad-debt problem and government intervention, may gradually be removed through
re-capitalization and commercialization. Other problems, such as the lack of human capital and competition, may also be addressed through training and by allowing the entry of foreign banks. It may take a very long time before these reforms can successfully be completed, but China is moving in that direction. However, even if the SOBs are fully re-capitalized and become truly commercial banks with the objective of maximizing profits, they will still not be effective financial intermediaries for the SMEs because of their centralized-hierarchical organizational structure.
Because SMEs generally are risky and lack reliable accounting information, lending to them requires an intensive effort by local branch managers to identify good firms and projects in their region. In a centralized-hierarchical organization, capital-allocation decisions are made at the centre, and local managers face uncertainty regarding the availability of capital when they discover a good project. As a result, local managers have weak incentives to exert effort in identifying good projects. Instead, they are more likely to deal with more established firms that they can easily convince the centre to lend. ...
This bias against SMEs cannot be resolved by decentralizing capital-allocation decisions within the hierarchically organized banks. ...
Allowing the entry of foreign banks will not solve the problem either. ...
The only way to ensure that the financial system will meet the financing needs of the SMEs in the non-state sector, then, is to establish locally based, small, single-manager financial institutions. To ensure that managers have the right incentives to exert an effort to identify good SMEs for investment, they should be given the ultimate right of control in allocating capital. To ensure hard budget constraints, these institutions should not be owned by a centralized organization. One way to establish such institutions is to allow the entry of private banks owned by the managers.
Proposal for a new financial system
There are about 25,000 rural townships in China. And on average there is about one rural credit cooperative (RCC) in each township. Their existence suggests that there is a large demand for rural financial institutions. However, the RCCs are tightly regulated by the central bank and have not been able to efficiently intermediate funds to the rural SMEs. We envisage the evolution of a dual financial system with a new set of private financial institutions that are locally based and largely outside state control. The rules of the game under which these institutions will operate will differ in key respects from those that govern existing institutions. Government regulations should be minimal and should not serve as a substitute for monitoring by depositors. In particular, depositors should be made fully aware of the risks they face by putting money into these institutions, and regulations should not give depositors any false sense of safety about their deposits.
The development of these new financial institutions does not mean that the existing, largely state-owned financial institutions and capital markets will not play a role. Rather, these institutions and markets will cater to larger firms and possibly new firms in the emerging high-tech sector. These new institutions will also play an important role in the long run. Over time, the best of these institutions will grow and evolve into comprehensive, regional-based (as opposed to locally-based) financial institutions. As they become more integrated into China's financial system, they will begin to serve a wider clientele. However, as long as there are small firms with unmet financial needs, the demand for some local-based intermediaries will remain. Those institutions that succeed the test of the market and expand over time will introduce much-needed competition for China's SOBs, much as China's township and village enterprises did in the 1980s. This kind of competition is likely to be much more effective than that offered by foreign banks, largely because of the differences in the kinds of firms the latter are likely to serve.
In conclusion, this paper provides a framework for thinking about
China's current economic difficulties, which is equally capable of
explaining pre-1994 dynamics. It puts at centre stage the functioning
of the financial system and the allocation of credit and investment
in the non-state sector. Contrary to much conventional wisdom, we
do not believe that weak aggregate demand lies behind the sluggish
growth, and thus are doubtful that expansionary fiscal policy or a
loosening of monetary policy can have the desired effect. Rather,
the problem is the inability of the financial system to intermediate
efficiently China's enormous savings and, more specifically, to direct
a larger portion of those savings to China's dynamic small and medium-sized
non-state enterprises, which have been the driving force in the economy
for almost two decades. Our analysis suggests a rethinking of issues
related to the design of China's financial system, and a renewed attention
to the development of locally-based, decentralized financial institutions
outside of the purview of state control.
*A.E. Safarian and Wendy Dobson, eds., East Asia in Transition: Economic and Security Challenges, HSBC Bank Canada Papers on Asia, Volume 6 (University of Toronto Press, 2002).
Note: Unless stated otherwise, all the numbers cited in this article are from various issues of the Statistical Yearbook of China.
1 Official Chinese statistics for the period 1998-2000 run counter to the view of sluggish growth. They report GNP increasing at robust rates of 7.5-8 percent. The general view among experts in and outside of China, however, is that the official data exaggerate GNP growth for these years. Actual growth may have been only half that suggested by official figures.
2 Since the early 1980s, China's savings rate has averaged 35 percent of national income. Approximately half of the annual savings is intermediated by China's financial institutions through the increase in deposits. By 1998, total deposits in all of China's financial institutions were 9.6 trillion RMB, which represents 123 percent of GNP.