V Investment System Reform
- David Burton, Wanda Tseng, Kalpana Kochhar, Hoe Khor, and Dubravko Mihaljek
- Published Date:
- September 1994
The recurring macroeconomic cycles in China during the past 15 years have been largely attributed to the excessive outlays on fixed investment by SOEs and local governments.70 Thus, controlling the excessive expansion in fixed asset investment has been a major focus of the present and past stabilization efforts. A key aspect of the current reform program to strengthen the infrastructure for macro-economic management is the restructuring of the investment system. This section examines the investment system to shed light on the process generating the stop-go macroeconomic cycles and discuss current plans for reforms. It covers the trends in fixed asset investment during the past 15 years; the institutional framework for investment decisions and allocation; and the plans for reforming the investment system.
Trends in Fixed Asset Investment
The share of fixed investment in GNP rose from about 20 percent in 1980 to a peak of about 32 percent in 1987–88 but fell to 25 percent in 1991 under the “rectification program,” when investment projects were drastically cut back (Chart 8). With the acceleration of reforms and the associated boom in fixed investment, the share of fixed investment in GNP increased sharply in 1992 and rose to almost 38 percent in 1993.
Chart 8.Fixed Investment and GNP
Source: Chinese auchortcies.
As the reforms took hold, the central authorities’ direct control over the investment process was gradually eroded. This is reflected in the decline of investment by state-owned units in total fixed investment from more than 80 percent in 1980 to about 60 percent in 1988-93 (Chart 9). Moreover, reflecting the decentralization of investment decisions, the share of investment subject to the center’s approval declined markedly. Available data for the capital construction component of fixed investment show that the share requiring central approval fell from 53 percent in 1990 to 44 percent in 1992. At the same time, the share of total fixed investment financed through budgetary appropriations fell from more than 30 percent in 1980 to less than 5 percent in 1992 (Table 12), mainly because of the budgetary constraint imposed by the steady erosion in the share of fiscal revenue in GNP during the period (see Section IV). The decline was offset by a corresponding rise in financing from retained earnings of enterprises, bank loans, and foreign capital.
Chart 9.Fixed Investment by Ownership
Source: Chinese authorities.
|Total fixed investment||100.0||100.0||100.0||100.0||100.0||100.0|
|By sources of financing|
|Total fixed investment/GNP||20.4||29.7||25.1||27.2||32.7||37.7|
Two important developments in 1992–93 are further indications of the diminishing influence of the central authorities over investment. First, although it is not apparent from the data, financing by enterprises through bonds or shares issued directly to the public—instead of through bank borrowing—has grown rapidly. Such practices have further undermined the ability of the central authorities to manage investment through the traditional controls on credit availability. Second, foreign direct investment in China has increased phenomenally. Actual inflows of foreign direct investment into China rose from an annual average of $3 billion in 1985–91 to $11 billion in 1992 and $25 billion in 1993.71
Investment System until 1993
Changes in the investment system over time can be examined in terms of the shifting relative roles of the key institutions involved in the investment process: the government agencies, primarily the SPC, the Ministry of Finance, and their counterparts at the local government level; the banking system; and enterprises.
Investment Allocation Process
Prior to 1978, fixed capital investment had to be allocated through the Ministry of Finance after approval by the planning agencies. The allocation of working capital to state enterprises was also channeled through the Ministry of Finance. Starting in 1978, changes were gradually introduced in the investment approval system. Most important, the central government reduced its role in the investment decision process by both decentralizing investment decisions below certain threshold levels to local governments and withdrawing budgetary grants for investment financing. In 1984, the thresholds were formalized at Y 50 million for investment in priority sectors, such as energy, transportation, and raw materials, and at Y 30 million for other sectors.72 Investments below these thresholds could be approved by provincial authorities. In cases in which enterprises were able to raise their own resources for financing amounts above these thresholds, central government approval was not always considered necessary.
During 1978–93, the investment approval process underwent some changes. The process began with the determination of the size of aggregate investment. This, in turn, depended on budgetary considerations, as current expenditures and investment on projects approved in earlier years were first deducted from projected revenues and the balance was then made available for investment; macroeconomic conditions; and material balances, that is, the physical availability of key inputs.73
Once total state investment was determined, the process of allocating resources among sectors and projects began. Sectoral allocation was heavily influenced by past patterns, and the completion of old projects was accorded priority over the launching of new projects. In addition, sectoral allocation depended on prevailing priorities of industrial policy and gradually also on market demand. In order to allocate funds among individual projects, technical, financial, and economic details of the specific project were evaluated. Projects approved by the SPC formed part of the state’s mandatory investment plan, and projects to be undertaken by local governments formed part of the local mandatory plan. Both were then combined to form the basis for the fixed investment component of the credit plan.
Projects approved by the SPC were guaranteed supplies of scarce raw materials under the material allocation plan of the investment approval process. However, the role of the material allocation plan has declined markedly in recent years: it was applied to as many as 837 goods in 1980, but to only 16 goods in 1993, including primarily steel, timber, rubber, coal, and some metal ores and products. The material allocation plan was applied to goods at three levels: goods subject to unified distribution under the central government (under the former Ministries of Materials and Commerce, now the Ministry of Internal Trade); goods subject to unified distribution under individual ministries; and a residual group subject to distribution under individual institutional arrangements. In the past, the prices of most goods subject to the material allocation plan were fixed, typically at levels below market prices. Consequently, the state’s share in investment in the early 1980s was underestimated. Even after planning was reduced or eliminated for many of these goods, the state continued to guarantee their availability to key projects, through a first-right-of-purchase option, but at market prices.
Financing of Investment
Before 1978, a large portion of the state-allocated funds took the form of grants provided directly through the budget, rather than loans. At that time, there were no specialized banks, and the monobank system that comprised the PBC and its branches played only a limited role—involving the allocation of some above-quota working capital funds to enterprises—in providing funds for fixed investment. The bank branches performed the bookkeeping task of recording the details of loans and associated financial flows to investing enterprises. No decisions were taken by bank branches, and their lending was not sensitive to profitability considerations. Also, lending carried no commercial risks for the bank branches.
Beginning in 1978, a number of changes took place in the financing of investment. In terms of the banking system, the monobank system was separated into a central bank—the PBC—and four specialized banks; direct budgetary grants for investment were reduced and replaced by bank loans that became part of the annual credit plan; and a limited discretionary role for lending decisions was permitted for the specialized banks. While the specialized banks’ operations were heavily circumscribed by the state credit plan and industrial policies, the banks were permitted some autonomy in selecting borrowers and projects. In this sense, banks began to undertake a combination of policy and commercial lending. Finally, the financial system was expanded to include new lending institutions, such as universal banks and NBFIs, which do not undertake policy lending. In recent years, a capital market has developed rapidly, centered around the two stock exchanges in Shenzhen and Shanghai, that allows certain enterprises to obtain equity financing.
Concomitant with the decline in the budgetary financing of investment, changes also occurred in the SOE sector that affected investment financing (see Section IV), SOEs were allowed to retain their depreciation funds as extrabudgetary funds. Profits were separated from taxes, and enterprises were permitted to retain a portion of their profits. Thus, earning retained in the extrabudgetary funds became an increasingly important source of investment finance, particularly for upgrading and expanding existing facilities. With the introduction of the fiscal contracting system between the central and local governments, the latter had incentives to shift revenue derived from enterprises under their jurisdiction into their extrabudgetary funds, which carried no obligations in terms of transfers to the central government.74
Despite the shift in the financing of investment from the budget to bank loans, the state continued to play an important role in the sectoral composition of investment through the allocation of “policy loans” from the banking system.75 Although there is no clear-cut definition of policy loans, according to official estimates in 1992, they varied considerably across banks, with the highest proportion in the PCBC (53 percent), followed by the ABC (48 percent), the BOC (22 percent), and the ICBC (18 percent). These loans encompassed four categories: fixed asset loans for basic industries and infrastructure; working capital loans for purchasing farm products and, until recently, export and import financing for state-owned trading companies; working capital loans for key SOEs; and loans supporting agriculture, poverty reduction, local development, and the development of science and technology.
In mid-1988, six sectoral state industrial corporations (SICs) were established to implement investment projects selected by the SPC. Administrative costs of the SICs were covered by the budget, and the SICs played virtually no role in project selection, other than to offer their comments. SICs were permitted to approve loans on their account without central government approval for projects that, as described above, were below the thresholds of Y 30 million and Y 50 million. Equity investment was also permitted, although such investment was limited in practice, as the SICs had no independent source of funds. SICs were also prohibited from adding a markup to loans, based on funds received by them from other sources.76 Projects administered by the SICs did enjoy the advantage of guaranteed access to scarce raw materials under the allocation plan. The SICs also served as an implementing vehicle for policy loans undertaken by the specialized banks. For example, the PCBC could, on the payment of a service fee, leave the disbursement and repayment of its policy loans to the relevant SIC.
Weaknesses of the Investment System
The investment system that has evolved since 1978 contains weaknesses that have become obstacles to the efforts to maintain macroeconomic stability. The approval mechanism for projects, through which the level and composition of fixed investment by state-owned units is determined, contains an expansionary bias, as it provides little incentive for the relevant authorities to take into account project risk and the cost of funds as reflected in the interest rates. The only constraint on investment has been the availability of funds. As a consequence, the state’s capacity to intervene in the investment process through the use of indirect instruments has been limited; the primary means of intervention is administrative, for example, through stricter enforcement of the ceiling on investments requiring approval, or through the discouragement of bank lending for investments not in line with industrial policy.77 At the same time, the effectiveness of the central government’s control has been weakened by its declining role in the financing of investment and the increasing recourse to alternative sources of finance (including retained earnings, extrabudgetary funds, bank loans, and bond and share issues).
Another problem in the investment system has been the weakening of the central authorities’ ability to implement monetary policy. As described in Section II, the head office of each specialized bank is assigned an aggregate lending quota under the credit plan, which is then distributed among the branches of the bank. Although, in theory, policy loans should receive priority over commercial loans, in practice, the opposite often prevails. Banks with limited deposit bases exhaust their funds by first lending to “nonpriority” users and then applying to the central bank for loans to meet their policy lending. The central bank normally complies, giving monetary policy an inherently expansionary bias.
The investment system also carries disadvantages for banks and is detrimental to the development of a market-based financial system. An important part of banks’ portfolios consists of policy loans that were made mandatorily, many of which may not be commercially sound. This has adversely affected portfolio quality and has also discouraged the banks from transforming themselves into commercial lending institutions that are responsible for the profit-and-loss implications of their loan decisions. At the microeconomic level, the system has led to distortions, as state enterprises with low profit margins have had priority in obtaining funds—and at lower interest rates—over more efficient enterprises outside the state sector.
The drawbacks of the traditional investment system have been recognized by the authorities, and plans were announced in late 1993 to reform the system. The broad aim of the reform is to move toward a new system in which most investments are determined primarily by market forces, so that the aggregate level of investment can be influenced through indirect instruments. Under the reform plan, investment projects will be separated into three categories: projects with social benefits, such as health and education, or science and culture, which will continue to be financed by the budget; key state infrastructure projects, which will need government approval and will be financed by the newly established policy banks; and commercial projects, which will be financed by borrowings from the (commercialized) specialized banks and other financial institutions, and through the rapidly emerging capital market.
It is expected that most projects will fall into the third category of commercial projects. These projects will no longer require state approval and will only have to be registered; the risks involved are to be borne fully by banks and enterprises. By introducing the element of risk and accountability into most investment decisions, the authorities hope that the bulk of investments will become sensitive to market mechanisms and thus influenced by indirect instruments of monetary policy. Under the proposed system, the authorities can also pursue their objective of ensuring sufficient funding for key infrastructure and other priority projects through the policy banks established explicitly for such purposes and through other preferential policies. On April 13, 1994, the SDB started operations, with plans to issue Y 65 billion of bonds in 1994 to provide financing for key state projects, including 345 medium-sized and large projects.78
It is clear that the reform of the investment system is closely intertwined with reforms in other sectors of the economy. In particular, the progress in achieving the objectives of the investment reform will depend on the speed with which a number of other steps can be taken, including the hardening of the budget constraints of the enterprises and banks; the elimination of price distortions, particularly in energy, transportation, housing, and other basic industries; the development of new financial institutions geared to providing long-term financing and a reliable capital market for equity financing; and, finally, the establishment of an adequate legal and regulatory framework.
For a further discussion of the role of fixed investment in the macroeconomic cycles in China, see Appendix II.
The value of foreign direct investment in 1992 is equivalent to almost 11 percent of total fixed investment reported for that year.
Initially, these thresholds applied to technical transformation investment; more stringent thresholds of Y 10 million (for productive investment) and Y 5 million (for unproductive investment) applied to capital construction. However, separate thresholds ceased to apply in the early 1990s as the distinction between the two types of investment became increasingly blurred. Initially, capital construction investment (for new projects) was financed by the budget, and technical transformation (for existing projects) was financed by depreciation funds. A distinction was also made on the basis of approval agencies until 1988, with the central and provincial branches of the SPC in charge of capital construction and the State Economic Commission in charge of approvals for technical transformation. With the governmental reorganization in 1988, the State Economic Commission was dissolved and its role merged with that of the SPC.
Foreign exchange inputs required for projects were also estimated, as well as the likely amount of foreign exchange available. The allocation of foreign exchange among alternative uses would be coordinated with the investment, credit, and raw material allocation plans.
The central government, however, imposed special levies on these extrabudgetary funds in order to recover some of the “lost” revenues.
Apart from policy loans for fixed assets extended by banks, there was an explicit category of loans, introduced after 1980, called “loans for replacing budgetary grants.” From 1985 onward, all loans for state-supported construction projects, as well as loans for various other purposes, were placed in this category. Later, a portion of these expenditures, particularly for health, education, and social services, was transferred back to the budget for financing.
The sources of funds for SIC loans included the budget (through the SPC); policy loans; construction bonds issued on behalf of the SICs by the specialized banks; provincial governments; and overseas borrowing.
The ceilings of Y 30 billion and Y 50 billion on investment approvals—for nonpriority and priority sectors, respectively—are easily circumvented by splitting up a project into several smaller components or by phasing a project, so that the first phase is only a small part of the total, while the subsequent phases are deemed to be continuations of the ongoing projects.
It was reported that the SDB would supersede the six SICs under the SPC and would be capitalized through budgetary transfers of Y 50 billion over a four-year period.