Information about Asia and the Pacific Asia y el Pacífico
Chapter

III Monetary Policy and Financial Sector Reforms

Author(s):
David Burton, Wanda Tseng, Kalpana Kochhar, Hoe Khor, and Dubravko Mihaljek
Published Date:
September 1994
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Since the inception of market-oriented reforms in China more than 15 years ago, the role, instruments, and conduct of monetary policy have undergone significant changes, as has the structure of the banking and financial systems. One of the most important changes was the creation of a two-tier banking system in 1984 when the PBC was established as a central bank, responsible for the conduct of monetary policy and supervision of the financial system, while policy and commercial lending operations were assigned to four specialized banks.23

The reforms also entailed changes in the framework of monetary policy, as well as in its instruments, and have greatly enhanced the role of monetary and credit policy in influencing aggregate demand. Nevertheless, important problems remain in the implementation of monetary policy and in the structure of the banking system and financial markets. This section outlines the main features of China’s existing monetary policy infrastructure (namely, instruments and institutions), evaluates its adequacy, and describes the reforms that the authorities are now undertaking to move to a more market-based system of monetary control that relies primarily on indirect instruments.

Structure of the Banking System

The PBC and the four large, state-owned specialized banks have a highly decentralized branch network totaling more than 120,000 branches throughout the country (Table 3). The organization of the branches is not based on economic criteria, but on the administrative structure of the country. Thus, each bank typically has a head office, about 30 provincial branches, 400 municipal- and prefecture-level branches, and 2,000 county-level branches. Some of the specialized banks even have sub-branches below the county level. Although still largely segmented in their respective activities, the specialized banks have been allowed to diversify their activities since 1985. However, a major activity of the specialized banks remains the provision of policy loans for investment projects, agricultural procurement, and external trade.

Table 3.Structure of the Financial System, 19921
No. of

Branches2
Assets

(In billions of yuan)
Banking system
PBC2,5501,016.8
Specialized banks
ICBC31,4951,430.0
ABC56,417789.0
BOC (domestic and foreign)7,1101,422.0
PCBC28,139816.0
Universal banks
Bank of Communications547106.1
China International Trust and Investment Corporation Industrial Bank626.3
China Everbright Bank (established 1993)1.5
Hua Xia Bank (established 1993)1.7
China Merchants Bank98.9
Fujian Industrial Bank75.7
Development banks
China Investment Bank3024.1
Guangdong Development Bank1115.6
Shenzhen Development Bank6.0
Other banks
Yantai Housing Saving Bank50.43
Bengbu Housing Saving Bank
Shenyang Cooperative Bank34
Chengdu Huitong City Cooperative Bank730.13
Cooperatives
RCCs52,763245.4
UCCs4,011110.5
Other deposit takers
Foreign deposit-taking banks695.54
Foreign joint-venture banks and finance companies422.63
Nonbank financial institutions
TICs and ITICs386224.5
People’s Insurance Company of China (domestic and foreign)4,23748.0
Finance companies2918.3
Financial leasing companies120.73
Security companies (Ministry of Finance)633
Security companies (PBC)87
Foreign insurance companies2
Sources: China Statistical Yearbook, 1993; Almanac of China Finance and Banking, 1993; and People’s Bank of China Annual Report, 1992.

In the past two years, many new financial institutions have been established. This table does not fully capture the diversification of the financial sector,

Includes all branches and savings deposit offices and business offices.

Figure for 1990.

In billions of U.S. dollars.

Sources: China Statistical Yearbook, 1993; Almanac of China Finance and Banking, 1993; and People’s Bank of China Annual Report, 1992.

In the past two years, many new financial institutions have been established. This table does not fully capture the diversification of the financial sector,

Includes all branches and savings deposit offices and business offices.

Figure for 1990.

In billions of U.S. dollars.

In addition to the four specialized banks, the commercial banking system consists of several national and regional universal or comprehensive banks and three development banks. Besides these, there exists a network of about 53,000 rural credit cooperatives (RCCs) and 4,000 urban credit cooperatives (UCCs). The RCCs collect deposits from, and extend credit to, rural households and enterprises, both on their own accounts and on behalf of the ABC. The UCCs perform similar functions in urban areas and are overseen by the other three specialized banks. In addition, foreign and joint-venture banks have established more than 300 representative offices and branches in China, which are engaged primarily in foreign currency banking activities.

There is also a large and growing network of nonbank financial intermediaries (NBFIs). These include trust and investment companies (TICs), affiliated in most cases with one of the specialized banks, which receive trust deposits from the Government, enterprises, and labor and insurance funds, trade securities, and issue guarantees; securities companies, affiliated and owned by the Ministry of Finance, specialized banks, and TICs, which are engaged mainly in trading all types of securities; financial leasing companies, owned by the commercial banks, which specialize in leasing operations; and the People’s Insurance Company of China.

Framework and Instruments of Monetary Policy

The framework for monetary policy and the key instruments have evolved considerably since the pre-reform period, during which credit was simply programmed to support output goals of the physical plan. Much has already been done to adapt the formulation and implementation of monetary policy to the changes in the economic system, in which planning controls have increasingly been supplemented with market mechanisms. While the credit plan remains the key to the monetary policy framework, its formulation has undergone considerable change, so that it is now no longer a “bottom-up” exercise focused on plan fulfillment. Indeed, the plan is formulated taking into account the annual macro-economic targets of inflation and real GDP growth. Likewise, while direct credit controls remain the most important monetary policy instrument, others, such as central bank lending, reserve requirements, and interest rates, have gained in importance, so that monetary policy is now implemented through a blend of direct and indirect controls.

Credit Plan

Prior to 1988, the state credit plan covered the domestic currency operations of only the specialized and universal banks.24 Since then, credit planning has been broadened to include credit extended by NBFIs and the direct financing of enterprises. However, it excludes credit to the Government. While the more comprehensive credit plan is submitted for information to the State Council, only the narrower credit plan, covering the specialized and universal banks, is subject to its approval. It is this narrower credit plan that is monitored most closely in practice. The more comprehensive credit plan includes a ceiling for aggregate credit in the economy, and, in the process of evaluating its consistency with the major macroeconomic targets and objectives, the PBC also monitors broader monetary aggregates. In this way, the PBC has moved toward a system of greater focus on total monetary expansion. A cash plan—a legacy from central planning, when it was necessary to cover the cash needs of the economy, such as wage payments and agricultural procurement—is also part of monetary policy formulation, but the target for the increase in currency is mainly indicative.

The credit plan is implemented through ceilings on credit of the specialized and universal banks.25 The PBC sets annual and quarterly ceilings for the head offices of each of these banks, which then set ceilings for their local branches.26 The credit plan also sets subceilings for specific types of loans such as working capital and fixed investment loans. While fixed investment credit is allocated by specific projects, banks have been given greater discretion with respect to working capital loans allocated by broad industrial sectors. The credit ceilings for the specialized banks are based on each bank’s share in total credit, as well as on the share of policy-based credit in total credit provided by the bank.27 Monitoring and enforcement of the credit ceilings of individual bank branches are conducted by both the local branches of the PBC and the headquarters of the specialized and universal banks.

Instruments of Monetary Policy

Aside from direct credit controls, monetary and credit aggregates in China are also influenced by PBC lending to the specialized banks, reserve requirements, and changes in administered interest rates.

PBC Lending to Specialized Banks

The purpose of PBC lending is twofold: first, it supports structural and socioeconomic development by filling the gap between bank deposits and credit plan targets; and, second, it manages overall bank liquidity through the granting of short-term credit.28 PBC lending consists of annual lending—primarily the credit required to meet credit plan targets—with maturities of one-two years; shorter-term lending to cover seasonal withdrawals of deposits, with maturities of two-four months; daily lending, with maturities of 10–20 days; and the rediscounting of commercial paper, with maturities of up to six months.

In addition to the specialized banks that are authorized to borrow directly from the PBC, some NBFIs are permitted limited access to the PBC’s credit facilities.29 Access to PBC lending is determined by an annual quota for each bank, which, in turn, is based on projections of its deposit growth and credit requirements. Quarterly quotas are also specified, but, until mid-1992, they remained essentially nonbinding, as banks were required only to meet their annual credit quotas. Furthermore, the PBC can adjust its lending quotas during the course of the year, taking account of the growth of deposits relative to credit plan targets for the banks, as well as of the overall liquidity situation of the economy. The maximum interest rate on PBC lending to financial institutions was set at 10.62 percent in 1994.

Reserve Requirements

Bank deposits are subject to a reserve requirement, currently set at 13 percent of domestic currency deposits.30 They apply to demand and time deposits of specialized and universal banks, as well as to RCCs, UCCs, and TICs. Fiscal and interbank deposits are excluded. Required reserves currently earn an interest rate of 9.18 percent. The monitoring of compliance with the reserve requirement for the specialized and universal banks is done at the branch level, rather than the headquarters level, and is based on end-of-month deposits. Reserve shortfalls are subject to penalty interest rates.

In general, financial institutions in China need to hold a relatively large proportion of their deposit base as “excess” reserves, primarily because of the shallowness of the interbank market and the inefficiency of funds management and the payments system. The high level of excess reserves also reflects the effects of the credit plan, combined with the existing structure of interest rates on PBC lending and reserve deposits. Excess reserves are used for settlement of payments, cash withdrawals, and on-lending in the interbank market. In 1989, the PBC issued a “guideline” on the level of excess reserves—5–7 percent of deposits—that it judged to be appropriate to satisfy banks’ operational needs. These deposits are, however, at the free disposal of banks. The excess reserve guideline is also based on end-of-month deposits, and excess reserves earn the same interest rate as required reserves.

Interest Rates

Although the effectiveness of interest rates as an instrument of monetary policy is limited because of the soft budget constraints of SOEs, their role has been increasing in importance. First, administered interest rates have been adjusted more frequently in the 1990s to take account of changing macro-economic circumstances. Also, banks have been allowed some flexibility in adjusting their lending rates (by up to 10 percent of the administered rate31). This being said, the effectiveness of interest rate changes is still largely felt through their impact on household savings, rather than on the demand for credit and the level or structure of investment, because of the continued availability of loans and subsidies to cover enterprise losses.

Money and Capital Markets

The short-term money market in China consists of an active, albeit localized and fragmented, interbank market. These local markets are organized mainly through financial intermediaries sponsored by local branches of the PBC. Besides banks, most NBFIs, notably TICs, and finance and securities companies are allowed to participate in the interbank market. The interbank market has been used by banks and NBFIs as a source of funding to meet their loan operation needs and for liquidity management. The maturity of interbank loans ranges from a few days to several months. Interest rates in this market are allowed to vary by up to 20–30 percent of the PBC’s maximum lending rate.

Since the early 1980s, the range of financial instruments has been progressively broadened to include not only cash and bank deposits but also treasury and other financial bonds, and equities. In particular, government securities began to be issued in 1981 through mandatory placement with households, enterprises, and local governments. Initially, the bonds had a maturity often years, but in 1985, and again in 1988, the maturity of the new bond issues was shortened to five years and three years, respectively.32 In 1987, the Government began to diversify its debt instruments with the issuance of “key construction bonds” to households and enterprises. The proceeds of these bonds were earmarked for capital expenditure in priority sectors.

Until 1991, the primary placement of bonds was entirely on a compulsory basis. In 1991, the authorities experimented with the voluntary placement of treasury bonds through underwriting syndicates. The experiment was highly successful, and, in 1992, all treasury bonds were issued through underwriters. During 1993, in an environment of strong demand pressures and disorderly financial conditions, including the proliferation of fund-raising schemes outside the formal financial system, the Government faced difficulties in placing bonds on a voluntary basis and reverted temporarily to compulsory bond placement. However, with the restoration of financial order since the second half of 1993, there have been no reports of forced sales of government securities.33 Indeed, the authorities have successfully sold more than Y 100 billion of both short-and long-term bonds in the first half of 1994.34 The range of financial instruments issued by entities other than the Government has also increased since the mid-1980s. Such instruments include enterprise bonds, financial bonds, commercial paper, and certificates of deposit.

Secondary bond trading was introduced on a nationwide basis in 1988. At first limited to the trading of treasury bonds, it was later extended to include key construction bonds, enterprise bonds, and other nongovernment securities. The volume of secondary market trading has increased rapidly, and the establishment of a national electronic trading system in 1991 linking several cities has served to reduce some of the earlier problems associated with the segmentation of the market.

Since the opening in 1990 of the two stock exchanges in Shanghai and Shenzhen, the market for these securities has burgeoned.35 Initially, only Chinese residents were allowed to hold and trade in enterprise shares (the so-called A shares). In early 1992, special issues of shares (known as B shares) were available for investment by foreigners.36 In 1993, shares of seven Chinese companies (referred to as H shares) were listed on the Hong Kong Stock Exchange, and shares of another two companies were listed on the New York Stock Exchange. Several other companies have been approved for listing on these exchanges in the near future.37 While enterprises can issue A and B shares or A and H shares, all three types cannot be issued by the same company. The market for these shares is segmented: domestic investors cannot buy B or H shares, whereas foreign investors cannot purchase A shares.

While the rapid development of new financial instruments, both long- and short-term, has served to increase the efficiency of financial intermediation, it has also complicated the task of monetary management by rendering the demand for key monetary aggregates much less predictable.38 Also, as will be discussed below, the weaknesses in the supervisory and regulatory framework are now even more apparent than before.

Principal Weaknesses of the Existing System

The key to understanding the weaknesses in China’s system of monetary and credit control lies in the fact that it has become increasingly inconsistent with the reforms in the rest of the economy. In particular, the reform process has emphasized the decentralization and devolution of economic decision making away from the center and diminished the role of the plan, thus rendering administrative methods of control progressively more difficult to apply and less effective. The ineffectiveness of the primary instrument—the credit plan—is evidenced by the frequent breaches of the planned limits on credit expansion, sometimes by substantial margins. Moreover, the recurring bouts of macroeconomic instability in China since 1978 are attributable, in part, to the underdeveloped state of indirect, market-based instruments of macroeconomic management. Where such instruments do exist, their efficacy has been blunted by the fact that the mechanisms by which changes in these instruments are transmitted to real economic activity—for example, interest rates and the exchange rate—do not reflect fully underlying demand and supply. Furthermore, many economic agents have not been strictly subject to the discipline of the market and have therefore not been responsive to price signals. The lack of a legal and regulatory institutional infrastructure has exacerbated these problems.

The weaknesses of the existing system of monetary control can be divided into those that arise from the formulation of credit policy and those that arise from its implementation. Notwithstanding the changes that have been made in the way that the credit plan is formulated, the process retains several elements of a bottom-up exercise. These elements impart an expansionary bias into the plan and complicate the task of grounding the credit plan in a consistent overall macroeconomic framework. The exclusion of credit to the Government from the credit plan is another potential source of expansionary bias.39 Also, to be credible, the credit plan needs to be rigid, which makes it difficult for the authorities to adapt the plan to take account of changing macroeconomic circumstances.

In addition, several factors have also served to weaken the implementation of monetary policy. The influence of the PBC, as a central bank, is circumscribed at the national level by its lack of administrative independence from the State Council, and at the local levels by a system of “dual leadership,” under which local PBC branches are dependent on local governments for housing, education, and other benefits. Moreover, the large number of PBC branches, which parallels the administrative structure of the Government, tends to leave them especially vulnerable to local political intervention and to weaken headquarters’ control. The large number of branches also reflects the backwardness of the payments system, which has caused the PBC to stand ready to meet the liquidity needs of the numerous local banks.

In the past, both PBC headquarters and its local branches were able to extend credit to eligible financial institutions; however, the extent of control of this lending by headquarters was progressively eroded as the process of decentralization advanced. Each quarter, PBC branches were allocated credit quotas by headquarters, which they were able to use to provide advances to banks. PBC branches were vulnerable to pressures from local governments to permit local banks to extend credit beyond the planned ceilings; these overruns subsequently had to be accommodated by base money creation. During the “rectification” period of 1989-90, the PBC strengthened its control over credit creation by local branches by requiring the latter to transfer to headquarters most deposits received from financial institutions. In addition, the lending capacity of PBC branches was restricted to the resources that it received from headquarters. However, controls were relaxed in the subsequent period. From 1992 to early 1993, branches of specialized banks came under considerable pressure to extend loans in excess of the credit plan; this, combined with the rapid slowdown in the growth of household deposits, left the PBC with no choice but to provide funds to the banks to cover credit for their planned activities. (Table 4 presents major monetary aggregates, and Chart 3 shows the major factors contributing to the growth of reserve money over the past five years.) In July 1993, under the 16-Point Program, the ability of local PBC branches to extend credit, except for very short-term funds management purposes, was terminated.

Table 4.Money and Credit: Summary Indicators(In billions of yuan; end of period, unless otherwise specified)
198519861987198819891990199119921993
Broad money520.0672.2835.01,009.91,195.91,530.41,934.22,539.63,149.2
(Annual percent change)17.129.324.221.018.428.026.431.324.0
(Annualized quarterly growth rate, seasonally adjusted)24.440.916.55.731.227.721.930.839.0
Narrow money374.0474.2568.5695.0744.2879.31,122.01,500.91,868.6
(Annual percent change)10.026.819.922.37.118.227.633.824.5
(Annualized quarterly growth rate, seasonally adjusted)13.144.110.8–4.524.924.432.632.633.9
Reserve money228.6282.7322.3405.5501.7657.3825.2971.21,316.5
(Annual percent change)23.714.025.823.731.025.617.735.6
(Annualized quarterly growth rate, seasonally adjusted)23.928.520.034.619.525.216.339.7
Currency in circulation98.8121.8145.5213.3234.2264.1317.4432.9585.6
(Annual percent change)24.723.319.446.69.812.820.236.435.2
(Annualized quarterly growth rate, seasonally adjusted)28.354.013.219.210.619.824.547.419.1
Net domestic assets499.1668.3812.0979.71,158.71,437.71,796.92,384.62,990.6
(Annual percent change)33.921.520.718.324.125.032.725.4
(Annualized quarterly growth rate, seasonally adjusted)41.653.915.77.826.825.623.133.834.5
Domestic credit619.6820.41,001.11,172.41,371.61,696.02,039.32,504.93,067.2
(Annual percent change)19.332.422.017.117.023.720.222.822.4
(Annualized quarterly growth rate, seasonally adjusted)25.248.118.00.826.020.717.821.934.6
Sources: Chinese authorities; and IMF staff estimates.
Sources: Chinese authorities; and IMF staff estimates.

Chart 3.Factors Contributing to Changes in Reserve Money

(Semiannual data; change over 12 months as percent of initial stock of reserve money)

Sources: Chinese authorities: and IMF staff estimates.

The implementation of credit policy is also weakened because of credit expansion by NBFIs. While such credit expansion is included in the more comprehensive credit plan, compliance with the plan has proved much more difficult to monitor; accordingly, NBFIs have, as during 1992–93, been important sources of faster than planned credit and monetary expansion.

Another important factor that has weakened the conduct of monetary policy has been the behavior of banks with respect to their holdings of excess reserves. As noted above, banks typically hold deposits at the PBC well in excess of the reserve requirement. Several factors account for this. First, reserve requirements are imposed at the level of the individual bank branch; shortfalls in one branch cannot be offset against excesses in another. Second, the interbank market, although growing in depth, remains localized, fragmented, and relatively inefficient. Third, structural problems in the payments and settlement systems require each bank branch to hold a relatively large amount of excess reserves for operational purposes. Finally, the general lack of a strong profit motive among the state-owned banks, combined with the fact that excess reserves are remunerated at the same rate as required reserves and only slightly below the PBC lending rate, can induce banks to hold larger reserves than necessary.

From the point of view of monetary policy implementation, there are two important consequences of this overhang of excess reserves. First, small changes in reserve requirements would be largely ineffective, as banks would be able to comply with them without changing the amount of lending. Second, banks could potentially draw down these deposits to generate a rapid expansion of credit should the demand for it arise, as happened in late 1992 and early 1993. The latter factor complicates monetary management, as it results in the lack of a predictable relationship between reserve money expansion and broad money growth (Chart 4).

Chart 4.Monetary and Credit Aggregates

(Twelve-montrr percent change, unless otherwise specified)

Sources: Chinese authorities: and IMF staff estimates.

1 As percent of total deposits.

Interest rates have played only a limited role in controlling monetary aggregates mainly because, as mentioned above, most of the largest borrowers from the banking system—the SOEs—are unresponsive to changes in lending rates. Furthermore, changes in interest rates are, in general, subject to State Council approval, making the process time-consuming and subject to political considerations.

Finally, the effective implementation of credit policy through both direct and indirect instruments is seriously hampered by the inadequacies of the legal and regulatory framework, the financial accounting framework of the banks, and the inefficient payments and clearance system.

Reform Plans

Recognizing that the development of China’s financial system has thus far lagged behind the development of other sectors of the economy and that the existing monetary policy infrastructure is no longer compatible with the objective of developing a market-based economy, the authorities have laid out comprehensive plans to accelerate the reform of the financial system. The broad objectives of the reform are to set up a strong central bank, albeit under the leadership of the State Council, vested with the responsibility of formulating and implementing monetary policy without interference from other government agencies; to commercialize the banking system, so that the existing state-owned banks would operate on a purely commercial basis, while policy-based lending would be undertaken by newly created “policy banks”; and to establish a unified and competitive set of financial markets with strengthened prudential regulation and supervision.

Measures to reform the central bank include the enactment of a central banking law. The law is envisaged to delineate clearly the central bank’s main objectives and responsibilities and to provide the PBC with greater autonomy of action. The new law is expected to be enacted in 1994. The objective of monetary policy would primarily be to maintain the stability of the currency and the financial system, thereby creating conditions that would foster sustainable economic growth. To these ends, it is envisaged that the PBC will eventually be reorganized along regional lines that cut across several provinces, thus reducing its vulnerability to the influence of local governments. In addition, as noted above, the ability of local PBC branches to extend credit has been terminated, except for very short-term purposes (with maturities of no more than seven days), to allow the smooth functioning of the payments and clearance system and the management of funds. The primary responsibilities of these branches will include supervising banks in their jurisdictions, collecting data, and conducting research.

As for the conduct of monetary policy, a progressive shift to the use of indicative targeting of money, supported by operating procedures based on excess reserves of the banking system, is planned. The PBC would realize its objectives mainly through open market operations supplemented by the use of reserve requirements, discount rates, and changes in administered interest rates, while allowing lending and deposit interest rates to float within a predetermined band. The authorities envisage that, over time, open market operations will become the primary instrument of monetary policy, beginning with the use of available instruments, such as short-term PBC bills.40 Increasingly, open market operations would mainly be conducted through the trading of short-term treasury securities. As a first step, an open market operation center has been set up in Shanghai, and preparations are under way to begin such operations on an experimental basis. Trading would be conducted with short-term treasury bills, using the facilities of the Shanghai Stock Exchange. In addition, steps are being taken to improve the statistical reporting system to provide more timely and comprehensive information for policy analysis.

To increase the competitiveness of the banking system, the authorities plan to separate policy-based lending from the commercial activities of the specialized banks. In particular, it is planned to relieve the specialized banks of their obligations to provide policy-based loans and to allow them to operate on a purely commercial basis, thus making them fully responsible for their own profits and losses. The banks will remain state owned. In addition, the RCCs and the UCCs will be transformed into cooperatively owned commercial banks. The authorities are also considering permitting greater freedom of entry to joint-venture and foreign banks, and to allow them to engage in domestic currency operations. By the end of 1993, foreign financial institutions (including banks, insurance companies, and securities companies) had set up over 300 representative offices and branches in China. At present, foreign banks are permitted to engage only in foreign currency operations.41 Furthermore, the specialized banks will be required to sever financial relations with their NBFI subsidiaries. The NBFIs would then operate independently on a commercial basis under strict prudential supervision by the PBC, with the help of new regulations to be issued for this purpose.

The policy-based lending activities will be assumed by three newly created financial institutions, two of which were operational by July 1994. The State Development Bank (SDB), which is responsible for providing low-interest financing for key infrastructure projects and certain basic industries, became operational in April 1994.42 The SDB is to be financed through appropriations from the Ministry of Finance and from existing funds for key construction projects, bonds issued to banking institutions and the public, and a portion of the deposits of the PCBC. It is expected that the state budget will provide for about Y 50 billion over the next four years to capitalize the SDB. In addition, the SDB has announced a plan to float Y 65 billion in longer-term bonds (issued to financial institutions) in 1994. The first issue took place in April 1994, with the sale of bonds worth Y 28.5 billion. The SDB may also sell bonds directly to the public in the future.

The China Import and Export Bank—which became operational in July 1994—will provide buyers and sellers with longer-term credit for imports and exports of capital goods related to the mechanical and electrical sectors, as well as for complete sets of equipment. It will be financed with capital from the Ministry of Finance and through the issuance of bonds. The Agricultural Development Bank of China will focus on financing the state procurement of agricultural products, and on agricultural development; it will be financed with bonds issued to financial institutions.

To foster the development of well-functioning money markets, the authorities aim to (1) create a market for short-term (maturities of less than one year) treasury securities, which would be issued mainly to specialized banks and institutional investors; (2) break down the segmentation of the existing interbank money market to promote the development of a national interbank market; (3) gradually liberalize interbank interest rates; and (4) strengthen the regulation and supervision of the interbank market. These measures would enable open market operations to become over time the main instrument of monetary policy.

The authorities plan to develop longer-term capital markets by establishing pension funds, mortgage companies, and other sources of long-term capital; by strengthening the regulation of securities markets through the enactment of a national securities law; and by closely supervising the issuance of securities in primary capital markets.

Also, there have been important changes in the government bond sales program for 1994. First, with the decision to terminate deficit financing by the PBC, the authorities have announced a plan to sell some Y 100 billion in treasury bonds in 1994. Second, a program has been introduced to diversify the type and maturity of government activities. In January 1994, the authorities sold Y 5 billion of six-month and Y 8 billion of one-year treasury bills in book entry form. From April to June 1994, the authorities sold Y 27 billion of two-year bonds with an interest rate of 13 percent and Y 60 billion of three-year savings bonds with an interest rate of 13.96 percent if held to maturity. However, the savings bonds are redeemable after six months on a graduated scale of interest payments that range slightly higher than the current interest rates on bank deposits of the corresponding maturities. In addition, Y 2 billion of five-year bonds were also issued. In general, the authorities have recognized the need for greater flexibility in interest rates to facilitate the voluntary placement of government debt instruments and to foster the development of an efficient and well-functioning capital market.

The new round of financial sector reforms is essential for the establishment of a market-based economic system. At the same time, it should be recognized that several challenging problems will need to be resolved when implementing these ambitious reforms. To enable the PBC to perform its two primary functions, namely, the formulation and implementation of monetary policy and the supervision of the financial sector, it will be necessary for the PBC to strengthen its policy research capability and conduct studies on the behavior of monetary aggregates in relation to the ultimate targets of monetary policy, and in relation to the chosen operational targets. It will also be necessary to develop rapidly the necessary infrastructure and the capability to conduct effective supervision and regulation.

As for the banking system, the commercialization of the specialized banks will require not only the establishment of the policy banks but also the identification and quantification of nonperforming loans in the specialized banks’ portfolios, so that the necessary capitalization can be determined. Problems regarding reductions in the number of bank branches and redeployment of staff (both of the PBC and the specialized banks) could also pose major challenges. In this regard, however, the authorities are confident that, with appropriate training, the staffs of these institutions can be absorbed in the growing services sector, particularly those involved in providing financial services. Above all, it will be necessary to reorient the behavior of banks and SOEs to make them more competitive and profit oriented by hardening their budget constraints and making them more responsive to market signals.

23

These are the Bank of China (BOC), the Industrial and Commercial Bank of China (ICBC), the People’s Construction Bank of China (PCBC), and the Agricultural Bank of China (ABC).

24

The foreign currency operations of the BOC and the other specialized banks were not covered under the credit plan. A part of those operations was covered by the foreign exchange plan, which was abolished effective January 1, 1994 (see Section II).

25

The authorities use the term “credit quotas” instead of credit ceilings. This terminology is a carryover from the old system of mandatory planning, when the credit expansion allocated to each bank was seen as a target to be achieved.

26

Local PBC branches were also permitted to allocate a percentage of credit under the plan within their localities, so that they could influence the direction of credit in their jurisdictions. For example, in 1991, about 7 percent of the credit plan was set aside for the local PBC branches to allocate within their localities. Separate credit ceilings were set for the PBC branches in Shanghai and Shenzhen, which, in turn, set ceilings for the specialized and universal banks in their regions.

27

Policy-based lending is a quasi-fiscal operation undertaken by the specialized banks at the behest of the state in support of specific agricultural and industrial development policies.

28

PBC lending, in conjunction with required reserves, has a redistributive element, as the PBC generally acts as an intermediary to redistribute funds from surplus to deficit banks and from surplus to deficit provinces.

29

Approved NBFIs must open a settlement account with the PBC if they wish to access the PBC’s credit facilities.

30

Reserve requirements were most recently adjusted from 12 percent to 13 percent in September 1988. These reserve deposits represent the portion of banks’ current accounts that is not available for withdrawal or settlement of interbank transactions, that is, they are “frozen assets.”

31

That is, if the administered rate is 10 percent, banks are allowed to charge up to M percent on their loans.

32

The length of maturity of the bonds issued in the 1980s implied a significant bunching of maturities in the 1990-93 period. Unable to fully redeem the maturing debt, part of the bonds held by enterprises was rolled over into five-year conversion bonds in 1990 and 1991.

33

In general, interest rates on government bonds are linked to those on bank deposits of similar maturities. In 1994, longer-term government bonds began to be indexed for inflation, although the precise nature of this indexation is not known.

34

See the discussion below on reform plans for more details on treasury security issues during 1994.

35

The number of shares listed on these two exchanges had risen to about 240 in early 1994, and the market capitalization is estimated at over Y 400 billion.

36

Both A and B shares are denominated in renminbi; however, B shares are quoted and must be purchased with foreign exchange.

37

The authorities have decided to postpone the listings of A shares during 1994 to bolster the stock markets, which have been flagging since mid-1993, owing in part to a glut of stocks in the market. In addition, the authorities are considering introducing a requirement that SOEs that are to be listed go through a six-month adjustment and consolidation program to improve their management and organization before issuing equity.

38

The issue is addressed in Appendix IV.

39

With effect from January 1, 1994, direct government borrowing from the central bank to finance the deficit was terminated.

40

In 1993, short-term PBC bills totaling Y 20 billion were issued through the interbank market and placed with financial institutions in certain parts of the country in an attempt to mop up excess liquidity.

41

In 1994, the authorities announced their intention to allow selected foreign banks to conduct business in domestic currency on an experimental basis.

42

The SDB is essentially a merger of several investment corporations previously under the State Planning Commission, which will continue to make decisions on target projects.

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