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The Changing Role of Macroeconomic Policies in China

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1990
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Issues in the implementation of market-oriented reforms

One of the most prominent economic developments of recent times has been the rapid spread of market-oriented reforms in the centrally planned economies of Eastern Europe and Asia. China has been implementing market-oriented reforms for over a decade and offers useful experience with macroeconomic management of a country in transition. While the current austerity program has put certain aspects of the process on hold, and the future course of reforms has not been fully articulated, the role of market forces in China’s economy is quite substantial, with visible influence across the entire economic landscape.

China began to reform its economy in 1978, to make it responsive to market forces and, thus, more dynamic and efficient. To this end, reforms have attempted to decentralize the economic decision-making process, giving economic agents more autonomy and making managers of enterprises more responsible than before for their profits and losses. China has attempted to foster competition, to increase the visibility of market signals, and, above all, to reduce administrative controls and remove regulations.

With the diminution of the role of central planning in resource allocation, the functions and objectives of macroeconomic policy are altered. In a market-oriented system, the emphasis shifts to the use of indirect levers of macroeconomic management to guide and regulate the behavior of increasingly autonomous economic agents. The experience of China in the areas of fiscal and monetary policies has been instructive because, first, new instruments have been developed and second, the government has encountered serious difficulties in quickly adapting its policies to meet the needs of the changing economic system.

This article is based on two longer studies by the authors: “The Evolving Role of Tax Policy in China” by Mario I. Blejer and Gyorgy Szapary, Journal of Competitive Economics, September 1990; and “Monetary Policy and System Reforms in China” by Gyorgy Szapary (paper presented at the IXth Latin American Meeting of the Econometric Society, Santiago, Chile, August 1989). These papers are available from the authors.

Nature of Chinese reforms

China’s economic reforms have involved regional and sectoral decentralization, more reliance on market forces in setting prices and determining output, the development of nonstate activities, and an opening of the economy to the outside world. Starting with agriculture, where market-based reforms were the easiest to undertake, the reforms were gradually extended to the industrial sector, where enterprises were allowed to retain a substantial part of their earnings and were given greater freedom in decision making.

A salient feature of China’s reforms has been the adoption of the “contract responsibility system” for enterprises that gives managerial autonomy while preserving state ownership. Various forms of management contracts have been implemented, involving undertakings by the enterprise management to meet government targets—typically on output, taxes, and profit levels—in exchange for greater freedom over investment decisions, composition of output, prices, wages, and other enterprise policies. Another important aspect of reform has been regional decentralization, with greater autonomy in decision making for local governments.

The reforms produced impressive economic growth: real GNP grew, on average, by almost 10 percent per annum during 1979–88, with both rural and urban living standards rising substantially. Exports were diversified and more than doubled their share of GNP. At the same time, household savings rose substantially, allowing a high rate of investment without excessive reliance on foreign borrowing.

But new problems emerged in the process of implementing the reforms. The Chinese economy is still a mixed one, with central planning and market mechanisms coexisting. A distinctive feature of this structure is a “two-track” price system. Typically, the producer negotiates with the government a certain production quota to be sold at regulated prices; additional output can be sold at market prices or at negotiated prices within government-guided limits. Production decisions at the margin are, therefore, influenced by market signals, even though about half of all transactions still takes place at regulated prices. This system has tended to reduce price distortions and increase efficiency. However, it has also constrained the efficient use of macroeconomic policy instruments, because the government has to influence the behavior of producers facing different input and output prices, making it difficult to evaluate and predict the impact of specific policy measures.

The incentives arising from the decentralization and liberalization also unleashed productive forces that, at times, led to expansionary pressures that the government was unable to control immediately because it lacked appropriate instruments. In 1988, for example, these pressures led to an unprecedented surge in inflation (close to 30 percent by the end of the year), prompting the Government to increase its reliance on administrative controls. This experience clearly underscores the importance of developing appropriate macroeconomic instruments to govern an economy as it evolves toward a new economic structure. Otherwise, the reform process may be disrupted by “stop-go” cycles that negate the very benefits that the reforms were designed to bring.

Fiscal policy

In the initial years of the reforms, large budget deficits were recorded, averaging over 3 percent of GNP per annum. Beginning in 1981, the emphasis of macroeconomic policies was shifted toward stabilization, and the deficit fell to as low as 0.5 percent in 1985. Since then, however, the deficit has been rising again, as government revenue has been falling faster than expenditure in relation to GNP, and in 1989 the deficit reached about 2 percent of GNP. Revenue fell from 34 percent of GNP in 1978 to less than 20 percent in 1989, reflecting mainly a continuous decline in revenue from the enterprise sector. Although part of this decline was the intended outcome of the decentralization process, the declining trend also reflects a number of unintended tax consequences of the reforms.

Reform of the tax system has been an important part of China’s systemic reforms. Prior to 1979, enterprises remitted all their profits to the budget and, in turn, the government provided them with investment finance and working capital. Enterprises were not responsible for their financial results and, therefore, had little incentive to improve efficiency and productivity, or to avoid losses that were, in any case, covered by the government. In order to provide incentives, beginning in 1979 a growing number of enterprises were subject to taxation and allowed to retain a portion of their profits to be used for investment and for bonus payments to management and labor. By 1986, almost all enterprise profits were taxed, instead of being remitted to the government.

There are problems, however, with the current system of taxes on enterprise profits. One is the lack of uniformity resulting from the much larger degree of discretion in setting taxes than in the tax systems of market economies. On top of the regular corporate tax, China applies a so-called adjustment tax on individual enterprises, to compensate for differences in profitability arising from factors beyond the control of enterprises, such as the setting of administered prices. Since the adjustment tax is designed to equalize profit levels, it is applied at different rates for different enterprises. The variations can be significant.

Indirect taxes also vary greatly. These taxes are collected directly from enterprises and, unlike in market economies, they often cannot be shifted forward to consumers because of price controls. In addition to their revenue-generating potential, they are also used to compensate for perceived variations in enterprise profitability arising from the continuation of price controls. The discretionary component of such taxes translates into a wide range of indirect tax rates.

Management contracts. The largest element of discretion, however, arises from the enterprise contract responsibility system. Under this system, which is applied to over 90 percent of state enterprises, the management of the enterprise signs a contract with the government (typically for a period of three to five years) stipulating a certain amount of profit to be realized and tax to be paid each year; profits above the contracted amount are either kept by the enterprise or taxed at a lower rate. In addition to reducing the buoyancy of revenue (by setting contractual ceilings on it for up to five years), the system limits the scope for using tax policy for macroeconomic management. While the contract is in effect, the central government is constrained in its ability to introduce new taxes or alter current ones in the face of changing economic circumstances. The loss of flexibility is all the more serious as the decreasing average tax rate embodied in most contracts tends to introduce a procyclical aggregate demand element into the tax system; that is, when economic activity increases, taxes as a proportion of GNP decline, and vice versa. This could undermine the ability of the Government to manage aggregate demand through the budget.

Another reason for the declining trend in revenue is the fall in taxable enterprise profits, resulting largely from price controls on the products of many enterprises. Many enterprises have seen increases in their costs but are not free to shift these costs to their prices. These increases have been caused mainly by higher input prices, higher depreciation rates resulting from more realistic accounting practices, and depreciation of the exchange rate. In addition, the greater autonomy of enterprises in the use of their financial resources has led them to rapidly increase their own wages and benefit payments.

Revenue sharing. Regional decentralization, an integral part of the reform process, has also tended to depress revenue collection and to reduce the revenue transferred to the central government. In China, virtually all major taxes are collected by local governments, which then remit a certain proportion of them to the central government. As local governments have gained greater autonomy, their desire to keep resources within their own province or city has increased, and the incentive to collect taxes that have to be shared with the center has diminished. The enterprise contract responsibility system has helped local authorities retain resources within their jurisdiction, since local governments are responsible for the negotiation of management contracts with the enterprises they own. Although the statutory tax rates are set by the central government, local authorities can, within the framework of contract negotiations, set effective tax rates through the establishment of quota profits and the rate of taxation of profits above those quotas. By receiving generous tax treatment from local governments, enterprises retain a larger portion of their earnings, which local authorities can then tap through “voluntary” contributions to the financing of local projects.

To address this problem and to increase the incentives to collect taxes, recent revenue-sharing arrangements between the central and local governments have been based on contracts that feature a quota arrangement, somewhat akin to the management contracts with enterprises. Under these arrangements, local governments agree to remit to the central government a fixed amount of revenue and retain all, or a major part, of the rest. The revenue to be transferred to the center is set for several years and usually features a fixed annual increment over the base year.

These new revenue-sharing contracts have further weakened the center’s control over, and flexibility in, the use of fiscal policy for macroeconomic purposes for two reasons. First, the contracts usually set a relatively low level (sometimes none) of incremental revenue transfer to the center, leaving increased amounts of resources to the local governments. Second, fixed quotas imply that the revenue transferred to the central government is not affected by the rate of growth of the economy that affects only the revenue of the local governments. Since the latter do not see themselves as having overall demand management responsibilities, the contracts compound the bias of the tax system that arises from the introduction of the enterprises’ contract responsibilities system toward a fall in the central government’s tax revenue as a proportion of GNP when economic growth increases.

Expenditure. Public expenditure has also been declining as a proportion of GNP, but at a slower rate than revenue. This raises the question whether the reform process has a built-in bias toward widening fiscal deficits. A faster decline in government expenditure has been constrained by three factors: (1) incomplete price reforms, leading to increased enterprise losses financed by budgetary subsidies; (2) a perceived need to raise consumer subsidies to compensate urban dwellers for higher food prices resulting from agricultural reforms; and (3) the limited success of the government in transferring investment responsibilities to enterprises commensurate with the growth in their retained earnings. In view of these factors, and considering that further reforms are likely to put additional pressure on government expenditure—for instance, because of the need to create new safety net arrangements for those adversely affected by reforms—streamlining of the tax system and revenue-sharing arrangements with local governments is critical. Without revenue-enhancing measures, serious fiscal and macroeconomic imbalances may emerge and slow down the reform process.

Monetary policy

In the evolution toward a market-oriented economic system, the role of money and monetary policy has also been transformed and heightened in China. First, with more resources left in the hands of enterprises and households, money is no longer only a counterpart to physical transactions, but is increasingly used as a store of wealth. This implies that in formulating monetary policy, more attention needs to be given to the demand for money as a financial asset and to the variables and policies that affect that demand. Second, price and trade liberalization has meant that growth in the money supply in excess of the demand for money will be increasingly reflected in overt inflation and balance of payments pressures. Finally, the increasing role of credit in the allocation of resources makes it necessary to improve the efficiency of credit markets to ensure that financial savings are channeled to the most productive uses.

Before the reforms, all commercial and central banking functions were handled by one “super bank,” the People’s Bank of China (PBC); with the exception of the Bank of China, which was responsible for foreign exchange operations, the other specialized banks were part of the PBC. Monetary policy was implemented through a dual payments system: a credit plan and a “cash” plan (currency in circulation). Credit was extended essentially to supply working capital to enterprises and was related to the accumulation of inventories. The cash plan, on the other hand, covered the sectors with a “need” for cash—basically for the payment of wages and the procurement of agricultural products. The PBC, however, had little control over the amount of currency in the system, which was decided by the planning authority.

The banking system has been substantially restructured since 1979. The PBC was transformed into a central bank, and four major specialized banks became responsible for commercial banking functions in their areas of specialization (e. g., the Agricultural Bank of China in agriculture, and the Industrial and Commercial Bank of China in industry and commerce). Increasingly, these banks have been allowed to extend their areas of operations to foster competition, although in practice their operations are still concentrated in their initially established areas. There are also two universal banks (which can operate in any sector) that compete with the specialized banks, and a large number of credit cooperatives and nonbank financial institutions. As a whole, the banking system is channeling more resources to enterprises, since bank credit has been increasingly substituted for budgetary grants to finance investment.

The PBC achieves its monetary targets through four major instruments: its own lending to banks, reserve requirements, control of interest rates, and credit ceilings. New financial instruments have also been created: Treasury bonds have been introduced to help control liquidity growth, specialized banks have started issuing their own bonds, and some enterprises have issued bonds. In some instances, these bonds are traded in secondary markets.

Monetary developments since the end of 1983 have been characterized by sharp fluctuations in money and credit; episodes of high inflation prompted a tightening of credit, but such restrictions were short-lived as pressures to relax credit began to increase when production slowed down. Firm implementation of monetary policy has been hindered by the limited capacity of the institutional framework to resist pressures for credit expansion. The close relationships between enterprises, the levels of government that own them, and financial institutions have undermined the ability of the PBC to enforce credit restraint for more than short periods of time.

The PBC has only limited autonomy over the formulation of monetary policy. The credit plan is elaborated as part of the overall planning process in coordination with the State Planning Commission and is approved by the State Council (cabinet of ministers). The PBC, therefore, lacks the ability to adjust its credit policy in the light of changing circumstances. The way in which the credit plan has been formulated has also contributed to an accommodative credit stance. The credit plan is developed “from the bottom up,” that is, local authorities submit their credit needs, which then become the subject of negotiation with the government at the center. Given the weakened role of the center in economic management, this system has imparted an expansionary bias to the credit program and has meant that the credit plan has not been firmly established within a general financial framework consistent with the central authorities’ macroeconomic targets. Moreover, the credit program has targeted currency in circulation (“cash”) rather than a broader monetary aggregate that also includes demand and time deposits. With the role of money as a financial asset increasing under the reforms, the practice of targeting cash does not allow the PBC to adjust credit policy to changes in the overall demand for money.

It is crucial for China to keep monetary policy on a steady and predictable course. Wide fluctuations in money growth and inflation undermine the credibility of monetary policy. Low credibility, in turn, makes the control of inflation and inflationary expectations more difficult and more costly in terms of foregone output growth. However, given the incomplete nature of the reforms, there are limits on the use of indirect instruments to implement monetary policy. For instance, the effectiveness of interest rate policy in allocating credit on the basis of market forces is constrained by the administrative setting of prices. Price controls also generate pressure for an accommodating credit policy to finance enterprise losses. Therefore, unless further reforms are implemented so that enterprises are responsive to prices that reflect underlying scarcities, it will be difficult for monetary policy to play its macroeconomic stabilization role effectively.

Overview

The changes brought about by economic reforms in China have highlighted the need to develop adequate macroeconomic instruments of control. Among these, fiscal and monetary policies play a central role. However, to fulfill their role, these instruments need to be refashioned so that they become an indirect lever of economic management rather than merely a tool for the administrative allocation of resources.

Recent experience shows that while policy instruments have indeed been transformed, serious problems still remain, weakening the ability of the central government to use effectively fiscal and monetary policies for macroeconomic management purposes. Problems for fiscal policymaking arise, in part, from the high degree of discretion and bargaining involved in setting revenue targets and the political pressures that they invite. The discretion embodied in the bargaining process detracts from the benefits of the reforms because it makes policy less predictable and effective.

Granting of greater autonomy to enterprises will not lead to more efficient allocation of resources if controls prevent prices from reflecting underlying scarcities and if enterprises do not have to face realistic and binding financing constraints. Discretion, in the form of case-by-case negotiation of taxation, softens these constraints, thereby working against allocative efficiency and reducing the effectiveness of fiscal policies.

Monetary policy should also play a central role in hardening the financing constraints facing enterprises. A key condition for implementing an effective monetary policy is a strong and autonomous central bank that is able to withstand pressures for an accommodating monetary policy. The commercial banks also have an important role in promoting financial discipline. By fostering competition among banks and making them responsible for their profits and losses, the government can encourage banks to become more strict in their risk assessment and make them better insulated from political pressures to extend credit.

In late 1988, China adopted an austerity program to bring inflation under control to create favorable conditions for a further deepening of reforms. As a result of the stabilization measures—a key element of which has been a significant tightening of credit though with greater reliance on administrative measures—the rate of inflation has been sharply reduced and the growth of output has substantially slowed. Although it is not clear what would be the pace of further economic reforms, taking advantage of the more stable economic environment, the authorities are introducing steps to strengthen the government’s ability to implement monetary and fiscal policy. These steps include a strengthening of the authority of the central bank and changes in the enterprise contract responsibility system, as well as in the revenue-sharing arrangements between provinces and the central government so as to enhance the buoyancy of taxes. While these steps are in the right direction, one can hardly exaggerate the difficulties of conducting an effective macroeconomic policy that fosters growth and financial stability without substantially reduced administrative interference in the allocation of resources.

NEW FROM THE INTERNATIONAL MONETARY FUND

INTERNATIONAL CAPITAL MARKETS: DEVELOPMENTS AND PROSPECTS

by a staff Team from the Exchange and Trade Relations and Research Departments

The report, a part of the World Economic and Financial Survey series, reviews trends in the main market segments and analyzes the forces underlying these developments. In particular the report discusses the progressive integration of markets and the related globalization of investor and borrower behavior. The efforts to promote an efficient and stable system of capital markets, trade liberalization in the financial services sector, international harmonization of tax systems, and recent initiatives to foster debt reduction for heavily indebted developing countries are also examined.

Available in English. ISBN 1-55775-137-4. viii + 111 pp. 1990.

US$20 00 *

*(An academic rate is available only to full-time students and faculty of degree-granting universities and colleges: US$12.00.)

To order, please write or call:

INTERNATIONAL MONETARY FUND

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Mario I. Blejer and Gyorgy Szapary

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