Information about Asia and the Pacific Asia y el Pacífico

Chapter 18 Controlling Inflation: A Principal Policy Challenge for China

Manuel Guitián, and Robert Mundell
Published Date:
June 1996
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Bijan B. Aghevli

It is a pleasure to participate in this conference on growth and inflation. The paper I will present addresses what many view to be the key policy challenge facing China today: namely, achieving sustainable rapid growth while reducing inflation on a lasting basis.

Previous speakers have already referred to the great economic strides made by China since reforms were initiated some 15 years ago. The economy has quadrupled over this period, and the associated productivity gains have led to substantial improvements in living standards. It is striking that a vibrant non-state sector has emerged as the principal vehicle of this transformation and now accounts for more than one-half of industrial output and two-thirds of GNP. Equally impressive has been the steady integration of China’s economy with the rest of the world through rapidly expanding trade and investment flows.

Notwithstanding these achievements, China’s economic performance has been characterized by recurring episodes of macroeconomic instability, with a sharp acceleration of inflation during periods of cyclical overheating. The intensification of such pressures has been most evident in the present cycle that began in late 1991, with inflation more than doubling to 13 percent in 1993 and accelerating further to 22 percent in 1994.

Against this background, the present paper first reviews inflationary developments since the early 1980s and examines the relationship between inflation and monetary growth. It then discusses the underlying causes of macroeconomic cycles in China. Finally, it outlines a policy framework for bringing down inflation on a lasting basis.

Inflationary Developments and Monetary Growth

Perhaps it is useful to start by asking a few questions about inflation in China. Has inflation really been a serious problem during the last 15 years of reform? What has been its relationship with monetary growth, and is this relationship expected to be maintained? These questions can be answered by looking at the main characteristics of inflation in a long-term perspective.

A principal point to note is that China’s average inflation rate—which provides some notion of the “underlying” or trend inflation rate—has been quite moderate—8 percent a year during 1982–94. Thus, while achieving a major structural transformation and rapid growth, China has been able to keep inflation at moderate levels. This performance is in sharp contrast to that of most other economies in transition, which have been plagued by very high inflation rates, particularly in the early stages of their reform process.

China’s moderate inflation during the past decade and a half has been attained despite a rapid monetary expansion (averaging 22 percent a year during 1982–94 (Figure 1)). The implied secular decline in the income velocity of money (by about 5 percent a year) during this period has been associated with the increasing monetization and financial deepening of the economy that have led to a sharp increase in the demand for money. In addition, with the range of available financial instruments being limited, a substantial portion of private saving, which rose rapidly during the 1980s, has been held in the form of money balances.1

Figure 1.China: Broad Money, Nominal GNP, and Velocity

Source: Chinese authorities.

1 Data for 1994 are shown on the basis of a new statistical methodology. Hence, they are not strictly comparable with earlier data.

This somewhat sanguine view of past inflation trends, however, offers little assurance that inflation will remain moderate if monetary aggregates continue to expand rapidly. The future course of inflation will depend critically on the extent to which the secular decline in the velocity of money is likely to continue. Looking at recent developments, one finds several reasons why the decline in velocity may not be sustained. The process of financial deepening and monetization appears to be slowing. There are also indications that economic agents may be less willing to hold money in light of the increasing availability of alternative financial instruments. Indeed, a recent IMF study2 identified a structural shift in the demand for money in 1988, when financial innovations and introduction of a secondary market in government securities opened access to financial assets carrying more market-determined interest rates. Furthermore, the more recent episode of financial disintermediation also attests to the changing nature of the demand for money. During 1992–93, when regulated deposit interest rates turned sharply negative in real terms as a result of accelerating inflation, households switched their financial savings out of bank deposits into various funding schemes, as well as into the then-nascent real estate and stock markets. To the extent that these factors are likely to slow the velocity decline, a continuation of rapid liquidity expansion carries with it a major risk of escalation in inflationary pressure.

Another aspect of the inflation process that gives cause for concern is its increasing volatility, attributable in part to the ongoing price liberalization and other reforms. To illustrate, the inflation rate dropped from about 18 percent in 1988–89 to less than 3fi percent in 1990–92, before climbing again to 22 percent in 1994. In addition to the adverse effects of the recent high inflation rates, the wider fluctuation in these rates can hamper growth by increasing uncertainty in economic decision making. Furthermore, the social consequences of recurring bouts of inflation inevitably undermine the reform process.

Recognizing, therefore, the importance of containing inflation, let us now look more closely at the nature of the macroeconomic cycles and the causes of the inflation China has experienced in the last several years.

Causes of Macroeconomic Cycles

The macroeconomic cycles since 1978 typically started with an increase in aggregate demand, reflecting the tendency of enterprises to translate the introduction of a new phase of reform into a call for higher investment and growth (Figures 2 and 3). The increase in demand was then ratified through credit expansion, reflecting the Government’s sanction of state-owned enterprise (SOE) investment plans and the limited autonomy of the banking system to turn down the loan requests. These developments next gave rise to the emergence of shortages and bottlenecks in critical sectors, thus intensifying pressures on prices and on the balance of payments. Subsequent attempts to stabilize the economy, primarily through the imposition of administrative controls, resulted in a sharp slowdown. This retrenchment, in turn, prompted renewed calls for credit relaxation, thus setting in train a further round of macroeconomic instability—as in the mid-1980s and again in the early 1990s.

Figure 2.China: Macroeconomic Cycles: Key Indicators1

(Twelve-month percent change, unless otherwise specified)

Sources: Chinese authorities; and IMF staff estimates.

1 Data for the first cycle, 1979–82, are not available.

2 Annual percent change.

Figure 3.China: Growth and Inflation

(Annual percentage change)

Source: Chinese authorities.

The occurrence of macroeconomic cycles can therefore be traced in large part to the monetary accommodation of surges in aggregate demand, followed by an abrupt tightening of financial policies. In the first instance, monetary policy has had to support the sizable credit demands of a weakly performing SOE sector, as well as the so-called policy lending of the Government. Many SOEs have required substantial resources to finance their ambitious investment plans, high wage increases, operating inefficiencies, and government-directed spending, such as social obligations to their workers. In the absence of a hard budget constraint, the SOE sector and the responsible local governments have frequently brought pressure to bear on banks to finance these outlays. The banking system has also provided a large volume of policy loans at the behest of the Government to finance priority government expenditures—such as key state projects, agricultural procurement and development, and trade financing.

To finance lending to SOEs and for policy purposes, the People’s Bank of China (PBC) has provided substantial funds to banks to supplement their own resources. As a result, the main source (about 70 percent) of reserve money growth in most recent years has been the PBC’s net lending to financial institutions. Thus, although direct government borrowing from the central bank for the state (government) budget has generally not been large, sizable PBC lending has gone toward financing a broad range of quasi-fiscal operations. Based on a very rough estimate of policy lending and operating losses of SOEs, the consolidated public sector deficit is estimated at about 6 percent of GNP during 1990–94, substantially higher than the state budget deficit of 2 percent of GNP.

Another factor contributing to the persistence of cycles has been the absence of effective institutions and instruments for macroeconomic management. Without such a policy framework, the authorities have been compelled to rely on administrative measures for economic stabilization. Such measures have tended to impose abrupt and at times excessive restraints on the economy, leading to countervailing pressures for subsequent relaxation. As a result, stabilization efforts adopted to reduce overheating have generally not succeeded in achieving a soft landing of the economy.

The authorities’ ability to facilitate a soft landing has been further hampered by the somewhat erratic nature of the mechanisms through which policy was transmitted to real economic activity. In particular, interest rates, relative prices, and exchange rates have not always reflected underlying demand and supply conditions. As a result, many economic agents were not subject to the discipline of the market and therefore did not respond to the price signals as they would have in a fully market-based system. This problem was compounded by a lack of adequate legal and regulatory institutional infrastructure.

In addition to the above factors, cost-push forces—such as adjustments in administered prices and wages—and exogenous supply shocks—such as natural disasters—also played a part in driving the inflationary process. While these forces generally had a one-off effect on prices, in some instances they contributed to a more sustained trend in inflation as they were validated by credit expansion. For example, the inflationary impact of price and wage reforms was more pronounced in 1987–88 and in 1994 when the economy was already overheated. This is not to suggest that the pace of reform was too fast; rather, new reforms were initiated without being accompanied by appropriately tight financial policies.

In 1994, a new dimension of the inflationary process emerged, as a large increase in the external surplus fueled reserve money creation. A sharp increase in exports and large inflows of foreign direct investment resulted in a marked strengthening of the external position. Despite PBC efforts at sterilization and a tightening of domestic credit, monetary aggregates grew sharply. Therefore, although food price increases and other structural adjustments contributed to the sharp rise in prices, it was excessive monetary expansion, fed mainly by the large balance of payments surplus, that validated these price increases.

Policy Objectives and Framework for 1995

Reducing inflation from the record high level of 1994 is the top priority on the authorities’ economic agenda. They recognize that continuing high inflation would seriously threaten the reform process, social stability, and the rapid development of the economy. Specifically, the authorities’ aim in 1995 is to lower average inflation to 15 percent, implying a single-digit rate by year-end, and to moderate growth to 8–9 percent. Thereafter, the efficiency gains resulting from the reforms are expected to sustain economic growth at 8–9 percent annually, while the continuation of appropriate financial policies would limit inflation to low single digits.

The attainment of the authorities’ objectives calls for a significant reduction in the consolidated public sector deficit and in liquidity expansion. A reduction in inflationary pressures will inevitably entail some slowing of output growth to a more sustainable level. If inflation is to be reduced without an excessive sacrificing of growth, however, it is necessary not only to adopt restrictive financial policies, but also to continue to implement structural reforms for facilitating an increase in potential output in the medium term.

The following discussion reviews the main elements of the policy framework to achieve noninflationary sustained growth. This framework is, in fact, broadly in line with that identified by the Chinese authorities. I shall first focus on fiscal policy and the related aspect of SOE reform. I shall next discuss the means of controlling domestic credit, touching also upon the development of indirect monetary instruments and financial sector reform. Finally, I will review the policy options for responding to the recent sharp improvement in the external position.

Fiscal Policy and Reform of State-Owned Enterprises

The improvement of the financial position of the public sector requires a comprehensive adjustment program to redress the structural weaknesses in taxation, contain government spending and government-directed lending, and undertake a fundamental reform of the SOE sector. Let us consider each of these areas.

First, on the revenue side, steps must be taken to reverse the secular decline in the tax ratio and strengthen intragovernmental revenue relations. To boost tax buoyancy, a comprehensive tax reform was undertaken in 1994—featuring a simplified, broadly based value-added tax (VAT), a unified domestic enterprise income tax, and a unified personal income tax. However, the continued decline in the tax ratio experienced in 1994 suggests that complementary efforts are needed to strengthen tax administration, especially to reduce statutory and ad hoc tax exemptions for enterprises and individuals. A vital step toward restructuring intragovernmental revenues was taken in 1994 with the adoption of a new system of revenue sharing between the central and local governments. It will be important to firmly implement this reform in 1995, with a view to gradually increasing the revenue share of the Central Government.

Second, both the central and local governments must control their expenditure more effectively. Current expenditure should be restrained through continued efforts to streamline public administration, including cuts in related spending. Also, it is essential to implement the new budget law as planned to strengthen the Central Government’s control over budgetary policy and to impose financial discipline on local governments. In this regard, the 1993 decision to eschew direct bank financing of the central government deficit—which was formalized in the new PBC law—bodes well for achieving the authorities’ objective of broadly balancing the budget over the medium term. In formulating fiscal adjustment, however, it is crucial to look beyond balancing the state budget and to pursue broader fiscal consolidation. Thus, it is necessary to reduce quasi-fiscal operations, in particular, policy lending, through the banking system.

Third, with regard to the broad fiscal implications of the SOE sector, the critical step is to limit SOEs’ access to credit for financing investment and operational losses. SOEs will have to be subjected to hard budget constraints, including, for example, through a more effective linking of pay increases to productivity gains. Decisive enterprise and financial sector reforms are essential for improving SOE performance, enforcing budget constraints, and allowing greater scope for bankruptcy. It is also necessary to take into account the future fiscal pressures that are likely to be entailed in restructuring the SOE sector. China’s chosen strategy calls for the promotion of autonomous shareholding companies within the framework of continued dominant public ownership. Experience in other countries has shown that such efforts, by themselves, do not necessarily improve enterprise profitability. It is thus encouraging that the Chinese authorities intend also to experiment with diverse forms of ownership, including through greater private sector participation.

Another key concern in this area relates to the financing of the social safety net, a heavy burden that would have to be removed from enterprises gradually. While these expenditures are expected in the future to be financed mainly from employee and employer contributions, with the latter derived in part from the profits of reformed SOEs, some budgetary impact could still remain. The need to absorb these and other restructuring costs heightens the urgency for substantially strengthening the underlying fiscal position. Against this background, the authorities’ intention to move the state enterprise sector to the forefront of the reform agenda in 1995 is indeed opportune and appropriate.

Control of Domestic Credit

The objective of lowering inflation in 1995 requires effective control over the growth of credit. The main elements of credit control include tight restraint on new PBC lending to banks; recall of short-term PBC credit to specialized banks; and adherence to the authorities’ credit plan. In particular, it will be important to resist credit demands for financing investments of local governments and SOEs, which in the past have been accommodated through an expanding and nonbinding credit plan. At the same time, closer monitoring of broad measures of credit and money will be necessary in view of the increased scope now available for lending outside the credit plan—given both the Government’s efforts to gradually allow greater autonomy for bank lending and the growth of financial institutions not covered under the credit plan.

The required strengthening of macroeconomic management calls not only for an appropriately tight credit policy, but also for improving the effectiveness of monetary policy instruments. To this end, a number of actions have already been taken, including the termination of direct government borrowing from the PBC; prohibition of lending by provincial PBC branches; improvements in the functioning of the interbank market; and the enactment, in early 1995, of a law governing the PBC. The PBC law holds much potential for enhancing central bank autonomy and strengthening the legal framework for monetary policy. It will be important for the Government to realize this potential by granting the central bank a more independent and effective role in exercising monetary restraint.

Intensified efforts are needed, however, to further develop indirect monetary instruments. Central to these efforts is the introduction of open market operations through the establishment of an integrated national interbank market in government securities and an improved payments system. Also, as a critical step toward market-determined interest rates, it is necessary to provide for a significant upward adjustment in administered rates and to rationalize their structure. Notwithstanding more frequent adjustment over the last few years, real interest rates continue to be substantially negative. Moreover, rate adjustments have so far been applicable mainly to household saving, rather than to investment credit for SOEs. To be effective, interest rate adjustments will have to be coordinated with the reform of the SOE sector.

Effective monetary management will also require reform of the financial sector in China. Some progress has been made, but the most difficult issues remain to be tackled. One is to successfully complete the separation of policy lending from commercial lending, which, given the sheer volume of policy lending, represents a major challenge. A first step in this direction was the establishment in 1994 of policy banks to take over the policy lending previously handled by the specialized banks. In addition to actually transferring lending operations to the policy banks, the next step will be to undertake the planned bond sales to finance part of such lending. A second area of focus will be to ensure that the specialized banks pursue commercial banking activities and develop their own lending criteria based on risk assessment. A third task is to address the issue of the banks’ nonperforming assets and the related problem of restructuring enterprise debt. Finally, it will be essential to establish a strengthened legal and regulatory framework. This process will require additional legislation governing the banking system—including the Commercial Banking Law, which is expected to be enacted soon—as well as the establishment of prudential central bank supervision over all financial institutions.

Policy Response to External Surplus

Let me now turn to the more recent issue of how best to deal with the inflationary implications of China’s large external surplus. The appropriate policy response depends in large part on whether the strengthening of the external surplus is temporary or permanent. The marked improvement in China’s external position in 1994 and early 1995 is attributable to both a rapid expansion of exports and a surge in capital inflows. Export growth is expected to remain strong in the future, although somewhat slower than its exceptionally high current pace, owing to productivity gains fostered by both foreign investment and the reform process. In particular, the exchange market reform has had a substantial beneficial impact through its indirect effects on the functioning of the market and economic efficiency. Similarly, capital inflows to China comprise mainly inflows of foreign direct investment. While these inflows are expected to level off, they are not likely to be reversed. Thus, although reflecting some temporary elements, the recent strengthening of China’s external position appears to be of an enduring nature.

It is clear that a medium-term policy response is needed to enable the economy to adjust to a sustained improvement in the external position. Let me now discuss the main policy options available for reducing overheating while using the additional external resources productively.


In China, as in most other countries faced with large capital inflows, the first line of defense has been to sterilize the monetary consequences of the large external surplus. While some further scope remains for such efforts in China, experience of other countries suggests that this course of action may be of limited value in the face of a sustained external surplus.

Exchange Rate Flexibility

Experience in other countries has also shown that the process of absorbing a large external surplus unavoidably results in a higher real exchange rate. To the extent that the nominal exchange rate is kept unchanged, the real appreciation will inevitably occur through a rise in inflation. From the viewpoint of macroeconomic stability, it would be preferable to effect this real appreciation through the adjustment of the nominal exchange rate, rather than through higher inflation. This option of greater exchange rate flexibility has been found to be most appropriate in countries faced with a competitive export sector derived from rapid productivity improvements, a large balance of payments surplus, and rising inflation. The need for exchange rate flexibility will inevitably depend on the effectiveness of other policy instruments in reducing aggregate demand. Let me now turn to these other instruments.

Fiscal Adjustment

The most effective means of achieving a reduction in aggregate demand in many countries has been to reduce the saving-investment gap of the public sector. In China, the strengthening of the external surplus reinforces the case for strong fiscal adjustment. A significant improvement in the underlying fiscal position, however, may not be attainable right away, given the deep-rooted nature of the fiscal problems discussed earlier.

External Liberalization

Yet another policy option is to take advantage of the easing of the external constraint by accelerating trade liberalization. I should first underscore the far-reaching reforms already undertaken in the external sector in 1994. Key initiatives were the January 1994 unification of exchange rates and the liberalization of access of domestic enterprises to foreign exchange for trade. Also noteworthy were the establishment of a nationally integrated foreign exchange market and the further liberalization of the trade system. Additional efforts to liberalize the external sector would not only help ease pressures on the domestic money supply but also increase the efficiency with which foreign resources are absorbed. These efforts would comprise steps to further liberalize trade, including additional reductions in tariffs and rationalization of the tariff structure as well as removal of nontariff import controls. With regard to the reform of the exchange system, the favorable experience of 1994 provides a unique opportunity to dismantle the few remaining current account restrictions—mostly on foreign-funded enterprises and services other than those relating to trade—and thereby pave the way for achieving current account convertibility.

Other Measures

Finally, there is scope both for reviewing the incentive and regulatory apparatus related to foreign direct investment and for slowing external borrowing (or prepaying external debt) as part of the response to equity inflows. In particular, it would be useful to streamline the system of investment incentives, with a view to making it more transparent, reducing its fiscal cost, and, more generally, giving equal treatment to foreign and domestic enterprises. The authorities have already initiated this process.

In conclusion, let me say that the authorities’ macroeconomic objectives reflect urgent and appropriate priorities at the present economic juncture. I would also like to stress the mutually reinforcing nature of structural reforms and macroeconomic stabilization in achieving these objectives. On the one hand, the stabilization strategy is intertwined with progress in SOE reform, improvement of macroeconomic policy infrastructure, financial sector reform, and external liberalization. On the other, financial stability can help provide a suitable climate for accelerating the reform process.

The achievement of noninflationary growth will depend crucially on two important aspects of policy implementation. First, it will be important for the authorities, in a break from the past, to resist potential SOE demands for easing credit restraint. It will be crucial to strengthen the PBC’s ability to do so, by granting the central bank adequate autonomy through a forceful implementation of the new PBC law.

Second, the likely continuing strength of the balance of payments will again pose a major challenge for policy implementation in 1995. To respond adequately to this challenge, the authorities will find it necessary to broaden their focus away from primary reliance on the credit plan toward a more coordinated approach involving other components of domestic asset creation, external sector policies, and fiscal policy.

The present situation calls for vigilance in monitoring the economic situation as it evolves and for adapting policies as necessary. The authorities’ awareness of these challenges and their pragmatic approach to policymaking augur well for the achievement of their macroeconomic targets, including in particular an enduring reduction in inflation.

1The decline in velocity in many planned economies has been attributed by some to the existence of repressed inflation in the economy, namely, real money balances that economic agents were forced to hold because goods were rationed at fixed prices. This factor does not appear to have been significant in the case of China, however, because the existence of a dual-track pricing system for most commodities and complete liberalization for a few others provided a means for eliminating any excess money balances through adjustments in market-determined prices.
2Wanda Tseng, and others, Economic Reform in China: A New Phase, Occasional Paper No. 114 (Washington: International Monetary Fund, December 1994).

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