Реферат: Redesigning the Dragon Financial Reform in the Peoples Republic of China

Redesigning the Dragon

Financial Reform in the Peoples Republic ofChina

Duncan Marshdmarsh@indiana.edu

Anna Pawulapawul@indiana.edu

DmitriMaslitchenko dmitri@mailroom.com

V550, GovernmentFinance in the Transitional Economies

21 November, 1996

            In 1978, the People’s Republic of China(PRC) embarked on the enormous undertaking of opening its doors to the outsideworld. Until this point in time,  the PRC had relied on a centralized economicsystem much like that of the former Soviet Union[1]. However, thePRC’s situation differed with the former Soviet Union in three substantial ways[2]1) although  reforms followed the Cultural Revolution (which did exact its tollon the Chinese economy) there was an absence of severe macroeconomic criseswhen reforms were begun 2) agricultural infrastructure was good, although theincentives were poor  and  3) China had a strong presence of overseas Chineseand Hong Kong that influence its economic development and over the yearssupplied capital and human resources.

            The industrialization strategy adopted bythe PRC  has been characterized by gradualism and experimentation. Its focushas been to introduce market forces, reduce mandatory planning, decentralize,and open the economy to foreign investment and trade[3]. This strategy had three main stages. The first (1979-1983) established four“Special Economic Zones” (areas awarded special freedoms to conduct businessrelatively free of the authorities intervention) in Guangdong and Fujianprovinces, the second (1984-1987) added 14 port cities creating the “EconomicDevelopment Zones”, and finally the third stage (1988-present) which openedmost of the country to foreign trade and created “tariff free zones”[4].  In the rural areas, land reforms spearheaded further reforms and also theestablishment of Township and Village Enterprises (TVEs).  These enterpriseswere able to capitalize on the abundant cheap labor in rural areas and tooperate without the burden of providing social spending.  They also provided atraining ground for the learning of market skills and concepts. Today,production of manufactured goods by rural and township enterprise is estimatedto account for more than 40% of the GDP.

            In many respects, China’s process ofeconomic reform has been highly successful.

Since its inception, theaverage GDP growth has been a world-leading 9.3% year, the poverty rate hasdeclined 60%, and 170 million Chinese living in absolute poverty have seentheir standard of living raised above the minimum poverty level.  Export growthwas 7.8% in 1993, 29% in 1994 and 34.7% in 1995.[5]  Governmentmeasures to control inflation, which had threatened to overheat the economy inthe early 1990s, seem to have taken effect: inflation was under 15% in 1995.(See Tables 1 and 2.)

Table 1.








Source: EIU Country Report,China/Mongolia, 3rd Quarter 1996. The EconomistIntelligence Unit.

Table 2.

Source: EIU Country Report,China/Mongolia, 3rd Quarter 1996. The EconomistIntelligence Unit.

Chinese economic reformhas one other characteristic that sets it apart from that of the former SovietUnion, the absence of democratic reforms. The current transition is beingcarried out within the “socialist framework” and  for the most part iscentrally controlled. Much of the world waited to see whether the economictransition would derail after the Tiananmen incident in 1989; it did not.However China did seem to be looking for a way of separating itself fromreforms and democratic upheaval that were happening in the former Soviet Union[6]. In 1992, Deng Xiao Ping toured the southern economic zones — a journeysignificant for its highly symbolic approval of the reform and investmentefforts he witnessed — and coined the phrase “socialist market economy”. Dengemphasized that this transition must promote the development of productivity,strengthen the national power and improve people’s standard of living, statingthat, “..with all these achievements secure, our socialist foundation isgreatly strengthened..”[7].

            Within this backdrop, we will take acloser look at the system of reforms currently underway in the People’sRepublic of China. This year marks the beginning of the Ninth Five-Year Plan(1996-2000).  Examining the individual parts (the budget process, public expenditure,taxes, banking, the interaction between central and provincial governments, andthe emerging need to transform the social safety net) will present a clearerpicture of what has been accomplished by the macroeconomic reforms put in placein 1976 as well as what still needs to be done.   


Revenue, Expenditure and the Budget

            One problem of major proportion facing theChinese government is that central government revenues are growing at a muchslower rate than the overall economy, and a growing budget deficit has resulted(see Table 3 in Appendix, page 20).[8]  This isespecially debilitating in the face of increasing demands from the surgingeconomy for investment in infrastructure and with the need for investment in areformed social insurance system that will come with economic disruptionscaused by continuing liberalization.  Expenditures have also been falling as apercentage of GDP, but are growing faster than revenue.

            Several factors have been identified inthe shrinking revenue-to-expenditures ratio problem:


·    Taxarrears on the industrial and commercial tax (CICT) from enterprises, which aregrowing as state-owned enterprises (SOEs) become more unprofitable in the faceof increasing competition.  At the end of 1994, these arrears amounted to 8.2billion yuan (¥), and just seven months later, the figure had grown to¥17.9 bn.[9]

·    Taxexemptions granted by local governments to state-owned and private enterprises.


·    Subsidiesto the loss-making SOEs, in the form of loans or direct subsidies (see Table4).  China’s 1995 budget deficit was around a mere 1.5% of GDP.  If policylending by centrally controlled banks — most of which is, effectively,transfers to SOEs which can never afford to pay back these loans — is takeninto account, the central government’s true deficit is 6% of GDP or higher.[10]

·    Pricesubsidies.  (Most of these were for urban food, and adjustments made in 1992have reduced this drain on the budget.)

·    Higherthan expected increases in expenditures (in 1995, these were 18% higher thanplanned on the central level, with local government expenditures over 30%higher than in 1994.)[11]

·    A dropof 10.7% in customs revenue from 1994 to 1995.

·    Inflation-indexedinterest subsidies on bank deposits and treasury bonds, which have been kepthigh by high inflation rates.

Table 4.




Source: Wong, Christine P.W., Christopher Heady, and Wing T. Woo.  FiscalManagement and Economic Reform in the People’s Republic of China.  OxfordUniversity Press.  Hong Kong: 1995.

            For a country controlled by a Communistparty, the government’s proportion of economic activity has been remarkablysmall, even before implementation of reform.  In 1995, official governmentspending was just 11.6% of GDP.  Off-the-books revenue raising schemes by localgovernments may mean the state’s total revenue is two times the official level.

            The extra-budgetary revenue investment wasdispersed, uncoordinated and did not fulfill the central government’sinvestment priorities.  The central government faced growing infrastructuredemands, but with shrinking (in proportionate terms) assets available, has beenforced to reduce capital construction spending substantially. Also,expenditures on administration, culture, education, and welfare increased overthe reform period, and reduced the government’s ability to spend oninfrastructure.[12]  (See Table 5in Appendix, page 22.)  The increases in administration spending areparticularly troubling, because of government policies to reduce control of theeconomy and shrink some government bureaus.

            One of the stated goals of the NinthFive-Year Plan is to eliminate the budget deficit by year 2000.  But this goalis highly unlikely to be achieved due to other conflicting goals, like spurringemployment, which may mean increasing subsidies to unprofitable SOEs; reducingregional income disparities; and strengthening agriculture, which is seen as akey to controlling inflation.

            Christine Wong, an expert on the Chinesefinancial system, identifies three necessary changes to restore the health ofthe budget:  First, the tax administration must be strengthened.  Second, thetax structure must be reformed so that it is neutral across products andsectors.  Third, the revenue-sharing system between local, provincial andnational levels of government must be revamped, with clearer tax assignments inline with each levels set of responsibilities.  The central government’scontrol over the tax system and share of total revenues will likely have to beincreased. The next two sections will address these proposed changes.[13]


The Pre-Reform Tax System

            Prior to economic reforms, China’s taxstructure was based on the Soviet model. Enterprises remitted their profit tothe government, retaining only what was necessary to pay expenses. Revenues werecollected by local governments, and a certain amount was filtered up to thecentral government.  In 1984, this was replaced by a system of enterpriseincome taxation reform, in which companies were taxed on their profits, as thegovernment tried to respond to economic imbalances created by the emergingprivate sector. The turnover tax (the Consolidated Industrial and CommercialTax, or CICT), which had been the largest contributor to the government’sannual revenue, was replaced with a business tax, a product tax, and avalue-added tax (VAT). These featured highly differentiated tax rates acrosssectors, types of good and service, and form of firm ownership. Most privatefirms paid a base tax rate of 33%, while most state-owned enterprises (SOEs)were nominally taxed at 55%.[14] In practice,however, taxes paid were governed by a contract responsibility system (CRS), inwhich enterprises negotiated individually with local government units.  Thissystem created conflict of interest because often the local government was bothtax collector and enterprise owner.  Not only were there differentiated rateswhich distort economic activity, there was little incentive for full taxremittance back to the central government under this system.  (See Table 6 inAppendix, page 23, for a description of the tax structure from 1985-1991.)

1994 Reforms

            In 1994, the Chinese government began torespond to these problems by enacting a series of reforms.  The CICT wasabolished and the following taxes were created or modified:

Enterprise Income Tax.  This unified corporationtax taxes companies at a single 33% rate.  Foreign enterprises and jointventures are still enjoying lighter tax burdens, because of the fiercecompetition between regions to attract foreign investment, but these privilegesare to be gradually eliminated.

Personal Income Tax.  Operates on a slidingscale, with a maximum of 45%. Not yet comprehensively-implemented.

Value-Added Tax (VAT).  Replaces the product taxof the CICT.  Most goods taxed at 17%, but agricultural and food products willbe taxed at 13%, and small-scale businesses will pay flat rate of 6%.

Consumption (Excise).  Focuses narrowly on“luxury goods:” tobacco, alcohol, gasoline, and a few others.

Business tax for services. Service industries will facea business tax of 3% to 20% on sales in place of the VAT.  This tax also willapply to transfer of intangible assets and the sale of real estate.[15]

Capital Gains.  A capital gains tax was tobe introduced in 1994, but its implementation was postponed because of concernover its adverse impact on China’s fledgling stock markets.

1996 Reforms

            In 1996, China announced plans to reduceits import tariff rate from 35.9% to 23%, while abolishing preferences forcertain goods and, importantly, eliminating exemptions from import tariffs(currently, over 80% of imports are exempt from import duties for variousreasons). [16] This step alone should help to reduce the recent losses in customs revenue. TheNinth Five-Year Plan also includes provisions to introduce taxes on interestearnings and inheritances, policies designed to reduce income disparity.

Revision of Tax Collection Structure

            In order to make the above tax policychanges effective, the tax collection system must be revamped and greatlyimproved.  The current structure is based on a system of revenue contractsbetween enterprise and government unit, and between local and centralgovernments. One of the necessary reforms involves tax exemptions, which localgovernments often have the authority to grant to enterprises who for one reasonor another are unable to pay their taxes.  This is a fundamental weakness inthe Chinese fiscal system: local government has decision-making authority togrant exemptions on a tax the proceeds of which may in large part be assignedto governments above.  Numerous conflicts of interest can appear to reduceincentives to enforce the tax at the local level.[17]

            To address these changes, China in 1994initiated the setting up of a centrally-managed National Tax Service. Thiswould replace the contract system with a national “tax system,” based onuniform rules of tax assignment and tax sharing.  Certain assignments will beassigned to local governments, and others to central government; others will beshared according to predetermined formulas.  Interestingly, in 1995, a specialpolice unit was set up to protect tax collectors under this new program.[18]

            A potential obstacle to tax reform comesfrom local governments.   Local governments have traditionally supportedreforms.  But this is because the reforms have usually given them greaterautonomy.  The tax system reforms need to restore some control over investmentand spending back to the central government, which could encounter localopposition.  Allowing local governments some discretion over local tax ratescan give them some of the autonomy they desire, and provide greater incentivefor intergovernmental cooperation.

            Few reports exist at present on theimplementation of these reforms.  Certainly, the spirit and scope of the reformshas been well-received by analysts, though more changes are advocated. But itwill take several more years to determine the success of the reform of taxcollection structures at the local level.

Intergovernmental FiscalRelationships

            A product of economic reforms intransitional economies is often a shift in intergovernmental fiscalrelationships. In the transition from centralized economy to market economy itis often from a relationship where the local or provincial government is thereceiver of the “plan” to the local or provincial government proceeds with agreater autonomy. The evolution of this relationship in the PRC has been verysimilar. However, the provincial or local governments were at an advantage overmany other transitional economies because the Chinese system had the followingcharacteristics 1)local implementation capacity was already established in therural areas 2)China in most areas has a high ethnic homogeneity and 3) therewas much to gain by inter-province trading[19]   

The very nature of Chineseeconomic reforms, gradual and incremental, allowed “scaffolding” of behavior.Partial reforms provided the environment to learn behaviors that could then beapplied to the next level of reform. Chinese economic reform was alsostructured on the idea of decentralization. The establishment of SpecialEconomic Zones (SEZs) encouraged the local areas to develop their ownstrategies to attract business and  allowed them the freedom to implement thestrategies. The very earliest reforms, breaking up of farm communes, were alsocarried out at the local level.

Many of the SEZs are doingvery well and people living in these areas are enjoying a higher standard ofliving than they had previously enjoyed. However, tax collection still remainsa difficult endeavor with compliance at only 70%.  In order to improve thepoorest areas in China, policies and programs that are able to move thisrevenue to the poorer areas will be needed. This can take the form of a betteraccounting system to ensure that all taxes due the central government forinfrastructure development actually arrive there.


Banking Reforms, State OwnedEnterprises and the Social Safety Net

            In order to put current economic reformsin perspective, understand the recommendations made by the internationaleconomic community, and fully address the quagmire of State Owned Enterprises(SOEs), a more in depth look at the interconnectedness of the SOEs and thebanking system must be taken. We will attempt to do just that using the contextof bank development in the PRC,  monetary policy,  and ongoing reforms to SOEs.

Reform of the bankingsystem in the PRC has taken on similar characteristics to reform in otherareas: i.e., gradual and experimental. At the beginning of reforms thefinancial sector in the PRC could hardly be called a financial sector[20].Financial sector development and implementation is a complex undertaking whichshould include  the development of institutions, instruments and markets[21].Currently in the PRC,  banking reform lags behind other areas of reform[22].This is due to a complex array of policy decisions. No discussion of bankingreform in the PRC would be complete without an examination of the current stateof SOEs restructuring. Many macroeconomic initiatives are being put on hold inorder to bolster a failing state sector and postpone the social upheavals thatmay be associated with the needed reforms of this sector.


The Central Bank wasestablished in 1984.  In 1987 two additional universal banks were formed andnon-bank financial institutions were started. In 1988 new capital markets wereformed and the secondary trade of government bonds was allowed. In 1990 theShanghai and Shenzhen stock exchanges were opened.  In 1992 all treasury bondswere issued through underwriters[23]. At the end of1994, the PRC had a total of 13 banks (of which 3 were specialized banks and 3were comprehensive banks). The new “financial system” contained 20 insurancecompanies, 391 trust and investment companies and greater than 60,000 credit cooperativesthat operate in local areas[24].

During the summer of 1995the central government announced  a series of new banking laws would beestablished. These laws were the People’s Bank of China Law, the CommercialBanking Law, the Negotiable Instruments Law and the Guarantee Law. Up untilthis time the roles of each party in the framework of  financial transaction hadn’t been clearly defined. These laws begin to lay the comprehensivegroundwork for financial transactions[25]. The People’sBank of China Law which was established in the summer of 1995 addresses theinternal organization of the People’s Bank of China, its monetary policy, itssupervision and  tries to establish  its autonomy from provincial and localgovernments (it is still under the control of the State Council). This law hasprovisions in it for setting the prime lending rate, rediscount window, amountof funds to be lent to commercial banks, and the trade of treasury bonds,government securities and foreign exchange. It also bars the People’s Bank ofChina from  financing the budget deficits of the central government and localgovernments. The  Commercial Banking Law addresses the mission of commercialbanks. These are still under the guidance of the State Council and still mustissue policy loans (although the law also states that any losses due todefaults on these loans will be compensated by the State Council).

The Negotiable InstrumentsLaw is similar to the United States’ Uniform Commercial Code. The Guarantee Lawdeals with mortgages, pledges, and liens. Both of these laws are hoped tostandardize and regulate credit transactions in the PRC[26].

Monetary Policy

Monetary policy in the PRCis currently administered through a  central “credit plan”.  This plan, whichis administered by the State Council, sets credit quotas for each bank and alsofacilitates direct bank financing of enterprises. In the current system themajor objectives of the specialized banks is to provide loans for variousprojects, agriculture and foreign trade.  The main recipients of these loansare the state owned enterprises (SOEs). The terms and rates of these loans arevery favorable (usually 12%[27]). Therefore thedemand for these loans is higher than the supply and private companies have torely on other sources. This can take on various means and can often lead tounderground lending operations.

            The convertibility of  RMB has also beenundergoing changes. Prior to January 1, 1994, there were two money systems inChina. One for local use, the other for foreigners. These Foreign ExchangeCertificates (FEC’s) were redeemable only in state operated stores andrestaurants. Only higher level officials were able to use these and mostimported goods required the use of FEC’s. Since doing away with FEC’s, RMBconvertibility was relegated to official “swap shops”[28].Now, with the correct permit businesses can use any large bank to exchangemoney. However, the government has also begun to establish hard currency auditsas well as trying to force businesses to use the same bank for all of theirtransactions (a way of tracking how much money is being exchanged). The newconvertibility does meet IMF requirements[29].

State Owned Enterprises and theSocial Safety Net

            As illustrated above, the banking systemand state owned enterprises are closely linked (see Table 7 in Appendix, page24, for financing of SOEs). According to Chinese government statistics, up to20% of the debt of state banks is bad debt. International estimates place thisfigure at almost double that amount[30]. Recently inJiangsu province, 30 SOEs  declared bankruptcy telling the banks they were notgoing to pay their debts. If all the banks in China did this it would lead tobankruptcy of the banks[31]. SOEs accountfor only 34% of industrial output but consume 73.5% of government investment[32].Most have an average debt equal to 75% of total assets[33]. According to an Oxford Analytica study, in the first eight months of 1995, SOEindustrial output expanded by only 8.3% compared with a 13.7% increase for allindustry.  And according to estimates, non-SOEs, on average, required less thana third as much investment to achieve equivalent industrial output.[34]

            These are serious problems. The ninth fiveyear economic plan (1996-2000) places priority on their eradication, callingfor SOEs to lay off workers to boost efficiency, and encouraging SOEs to“declare bankruptcy if their liabilities outstrip assets, if they makelong-term losses and if they lose out in market competition.”[35]Up until now current reforms and lessening of government controls have not onlynot reigned in this problem but have also created new ones such as assetstripping of the SOE by management, workers and local governments[36].

            However, the central and local governmentsare still hesitant to shut down even the most inefficient SOE. Currently, 7 outof 10 industrial workers work in a SOE. The SOE provides not only a job buthousing, education, pensions, insurance and often energy sources and commodityshops on site. The World Bank estimates that only 56% of total expenditure bySOEs is actually on wages, the rest is on “social spending”[37].   Therefore, any reform involving the SOEs must also involve reform anddevelopment of a social safety net. Pilot programs have been started  wherelocal governments create pension pools and are putting aside payroll taxes foreducation, health and unemployment benefits. It is also important to note thatthe question of “social security” reform is being worsened by additionalfactors. Population in the PRC is progressively growing older. This phenomenoncan be attributed to increase in life expectancy due to better livingconditions and the one child per family policy.

How Should Reforms be Implemented?

            Due to the interconnectedness of theseareas of society, many of these reforms need to be implemented simultaneously.In May of this year the World Bank published a Country Study[38]that attempts to address these issues. The following are proposed reforms fromthis study.

1)    Reduce the role ofgovernment in the directing of resources.

            This over time would lesson the StateCouncils role in directing the day to day functions of the banks and eventuallydo away with the credit plan. Banks would be able to allocate resourcesappropriately and to set their own interest rates.

2)    Improve the Central Bank’smanagement of monetary aggregates.

            This over time would improve theconsistency of banking laws by ensuring that they are used and would alsoremove policy lending from the banks and put it into the budget where it shouldbe. This would also allow for the development of the Central Bank as aninstitution.

3)    Transform state commercialbanks into real commercial banks.

            This step would help to free the banksfrom the current crises of bad debt and allow them to loan money to the newlyemerging private sector.

4) Improve governance, diversifyownership and lower subsidies for SOEs.

            In the short term this would includeimplementing an accounting system and independent audits, give autonomy to themanagers, getting rid of  unviable businesses and restructuring those SOEs thatcan be.

5)    Transfer social servicesto the government.

            This would reduce the burden on newlyrestructured enterprises. Over time this would allow for a national system tobe implemented.


            In comparison with other countriesundergoing transition from centrally-planned economic systems, China had theluxury of initiating its reforms at a time when it faced no macroeconomic orserious political crisis.  It was able to adopt a two-track approach toeconomic reform: China continued state control of existing enterprises whileloosening economic controls enough to permit growth of a new, nonstate sector. This was possible in part because the inefficient state sector was a smallshare of the economy, compared to most socialist nations.

            China’s reform experience thus far hasbeen one of “enabling” reform, allowing “marketization” instead of forcing“privatization,” getting government to “step out of the way” of the flows ofcommerce.  The results have been good to excellent in the productive sectors,but the reform has not yet succeeded in the fiscal and monetary sectors, whichare the domains of government.  Here the government can’t step out of the way;it must build the proper tools and structures to manage these sectors.[39] It is in these areas, and in the efforts to reduce administration, dismantleSOEs, and provide an adequate social insurance system for displaced workers andaffected citizens that China faces its true reform challenges.

            To further evaluate how far China has comedown the path of economic transition, we look to a definition of transitionused by the World Bank, which describes these three components:

·    Liberalization: freeing prices, trade and entry to markets from state controls, whilestabilizing the economy.  Stabilization is an essential component toliberalization.

·    Clarifyingproperty rights and privatizing them where necessary.  Requires re-creating theinstitutions that support market exchange and shape ownership, and especiallythe rule of law.

·    Reshapingsocial services and the social safety net to ease the pain of transition whilepropelling the reform process forward.

            Examination of the Chinese experienceshows that liberalization has taken place to some degree, though much reform ofprices, trade and markets is still to be done.  However, privatization and theassignment of property rights are still very undeveloped, and the mostdifficult parts of transition ahead are dependent on a still-unachievedtransfer of the social safety net from enterprise-based to government control.[40]

            Were China to continue to grow at therates of the last two decades, it would surpass the United States as theworld’s largest economy in less than twenty years.  Though some tapering off inthe growth rate is expected, China, with its sheer size and dynamism, isemerging as one of the world’s economic powers.  The reform policy choices itmakes during this period of transition thus have not only domestic butinternational significance, as China’s domestic economic and social stabilitywill be felt internationally. The rest of the world has ample reason forassisting China in seeing these reforms through peacefully. Opening of economicactivity within China and with the rest of the world will assist the process ofpolitical liberalization within the country, and will provide enhanced regionaland global security. 

 Table 3.  The Fiscal Situation inthe Reform Period

Source:  Wong,Christine P.W., Christopher Heady, and Wing T. Woo.  Fiscal Management andEconomic Reform in the People’s Republic of China.  Oxford UniversityPress.  Hong Kong: 1995, p.24.

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