(Reprinted from HKCER Letters, Vol. 17, November 1992) 


Development Strategy, Business Cycles
and Financial Reform in China

Justin Y. Lin


Economic Performances

In the last decade, China was one of the fastest growing economy in the whole world. During the period 1979-89, GNP per capita in China grew at the rate of 9.7 percent per year. This performance was better than those of the small Asian tigers of Hong Kong, Taiwan, South Korea and Singapore. In addition, the figure was for China as a whole. For the coastal provinces, from Shandong in the north down to Zhejiang, Jiangsu, Fujian, and Guangdong, the annual growth rate was 12 percent for the same period. In recorded human history, we have never seen such a fast growing economy covering such a vast area and for so long a period.

Despite rapid growth, the Chinese economy has repeatedly suffered from severe up-and-down cycles. There have been three such cycles since economic reform started in 1979. The introduction of the responsibility system in the rural areas, together with the increase of some agricultural prices in the late 1970s, set the economy on a high growth path for about two years. The fear of inflation in 1981 resulted in contractionary policies which brought the growth rate down from 7.8 percent in 1980 to 4.5 percent in 1981. The onset of urban economic reform and the freeing of prices of raw materials and energy pushed economic growth to 14.7 percent in 1984 and 13.8 percent the next year. Again, economic tightening sharply cut the growth rate to 8.4 percent in 1986. Attempts to reform enterprises and prices in 1987-88 initiated another phase of expansion, only to be accompanied by retrenchment policies towards the end of 1988, with the growth rate drastically lowered from 11.3 percent to 4.3 percent in 1989.

In comparison, consumption and the money supply fluctuated more or less in phase with the ups and downs of growth rates, while the changes in investment and bank loans were slightly leading and the price level slightly lagging behind the business cycles. In other words, all the major macroeconomic indicators experienced three rounds of cyclical movements in the last decade, the most severe of which being that of 1987-91.

Economic reform and liberalization are expected to generate rapid economic growth, but in China they also generate rapid overheating of the economy. Economic controls and retrenchment have to be introduced again as a consequence. These would predictably cool down the economy, but in China they also throttle economic activities altogether. These alternating episodes show that, in China, the effect of stop-go policies on business cycles are magnified enormously. It is natural to ask what have been the causes of such phenomena, whether they are avoidable in the future, and whether China can embark on a path of stable and sustained growth.

The blame for the recurrence of cycles has sometimes been misplaced. For example, it has been pointed out that non-state enterprises were responsible for economic disarray and overheating during times of reform, when they had more freedom. Such criticism, however, confuses the symptoms and the causes. It is true that non-state enterprises have developed rapidly in the last decade. In fact, it is such enterprises that account for the larger part of economic growth since the late 1970s. For the period 1979-90, industrial output by state enterprises grew at an annual rate of 7.6 percent, but that of collective enterprises grew much faster at 17.8 percent. The performance of rural collective enterprises has been even more impressive. Their share of national industrial output jumped from 9.1 percent in 1978 to 30.8 percent in 1991, which partly explains the outstanding economic achievement of the coastal provinces. Yet, as the following discussion will show, the rise of non-state enterprises cannot be held responsible for the severe business cycles in China.

Interest Rate Control

The main reason business cycles in China have unusually high frequencies and large amplitudes is artificially low interest rates that are rigidly controlled.

Interest rates in China have been artificially pegged at levels below what would prevail in the market. Low interest rates reduce the desire of the public to save, and thus decrease the supply of funds. They also increase the desire of enterprises to borrow, resulting in excess demand for funds. The central government has to control the amount of credit and practise credit rationing so as to hold down the stock of money supply. Credit rationing, however, does not get rid of the incentive on the part of enterprises to demand more funds. In such a system, the functions of banks were reduced to those of a cashier. Banks did not need to perform any kind of asset transformation or risk evaluation. Towards the end of 1984, as a result of economic reform, regional and local banks had more say on the granting of loans. They could make more loans if they received more deposits. Nevertheless, there was no corresponding policy to liberalize interest rates.

It was in such a financial environment that economic reform was carried out. In times of reform and liberalization, both consumption and investment demand rise sharply, while the control of credit becomes less strict. The non-state enterprises that have hitherto been rationed only small amount of funds take the opportunity to expand. Bank loans rise rapidly. If low interest rates are still to be maintained, the money supply would have to multiply rapidly. The economy soon becomes overheated. Non-state enterprises and state enterprises compete for resources and markets, revealing bottlenecks and shortages in areas such as energy, transportation, and raw materials. At the same time, prices spiral upward.

The resulting retrenchment is always characterized by the return to administrative controls of pricing and resource allocation. Capital and raw materials are rationed with priority to state enterprises, while activities of the more efficient non-state enterprises are greatly constrained. This sharply lowers consumption and investment, as well as the growth in bank credit and money supply. Nevertheless, the efficiency of state enterprises would not improve with the guaranteed supply of funds and raw materials. On the other hand, those enterprises run into hard times with the decrease in demand and the shrinking of the market. The subsidies to these state enterprises represent a heavy burden on the state budget. Soon the government will realize that there is no way to balance the budget unless the economy grows faster, thus beginning another phase of liberalization and expansion.

The overheating in 1984-85 was a result of low interest rates coupled with loose credit control. Given the greater supply of cheap credit, net fixed capital investment rose by 37.6 percent in 1984 and 94.4 percent in 1985. The money supply rose by 49.5 percent in 1984, well above the 20.6 percent in the previous year. To cool down the economy, credit was greatly tightened in 1986, resulting in an abrupt downturn. In 1986, the money supply increased by only 23.3 percent, while fixed capital investment dropped by 20.1 percent compared to 1985.

In 1988, following a short period of economic recovery, China went through another phase of overheating, repeating more or less the same cycle. The underlying factor was again rigid and low interest rates. However, this time the situation was complicated by the attempts to reform prices. As a result of the latter, there was widespread expectation of inflation. Rigid nominal interest rates in times of expected inflation reduce real interest rates to negative values, fuelling both consumption and investment demands. Not surprisingly, the total amount of credit granted nationwide greatly exceeded what had been planned.

Should interest rates be allowed to adjust to equilibrate the demand and supply of funds, then during economic upturns, interest rates would rise in response to the demand for funds, attracting more funds from the households who would now save more, and curtailing the demand for funds by enterprises. The resulting increase in money and credit will not be as sharp. The reverse will occur with an economic downturn. Free adjustment of interest rates can duly dampen business cycles in China.

Development Policies

The control of interest rates at low levels in China had its origin in the development strategy since 1952 which focused on heavy industry. The prolonged emphasis on heavy industry may well have been the single most important policy decision, whose consequences continue to play havoc with the development of the Chinese economy. Such a development strategy required resource allocations to be deliberately distorted, and could only be achieved through administrative means. Planning was an indispensable tool. State ownership of resources became a compelling necessity. Resource misallocation was accommodated by distorting the price structure, and through a system of rationing. Attempts to decentralize decision making and reduce central planning was never complete, and heavy industries always remained within the central plan. They symbolized the planned sector and became an institutionalized feature of the command economy.

In an impoverished, capital-scarce country, putting emphasis on heavy industry meant working against the economic principle of comparative advantage. One had to lower the cost of using capital by suppressing the interest rate. The cost of foreign exchange had to be depressed in order to protect these industries from foreign competition. This would also lower the cost of importing essential facilities and equipment used by heavy industry.

Since the return from investing in heavy industry could only be realized after a long time, a rapid rate of accumulation could only be assured by forced-up profits. To do this, a policy to guarantee low-wage rates and low raw material prices became an integral part of the strategy. For wage rates to remain low, it was important to provide essential items, like food, housing, medical care, education, and other social services at very low prices.

The result of all these policies to foster the growth of heavy industry was to generate a serious imbalance in the supply and demand for capital, foreign exchange, raw materials, various agricultural products, and essential goods and services. Economic shortage became a general and pervasive phenomenon.

On the other hand, there was still no guarantee that resources would voluntarily flow to those industries to which the state had set a high priority. To ensure that it took place, a system of centralized planning and management became imperative, an extreme but not unnatural solution for permanent economic shortages and distorted prices.

Another natural outcome is the emergence of state ownership of enterprises. Heavily regulated private enterprises would still be a threat to the central plan because there would be little incentive for owners to reinvest their profits in low-profit industries considered to be of high priority by the state. If the right to reinvest profits elsewhere is denied, then private ownership of enterprises ceases to exist for all practical purposes.

The creation of an elaborate system for allocating resources in all kinds of activities through administrative channels was essentially dictated by a development strategy that was predicated on an erroneous conception of the economic process. Comparative advantage was totally ignored and rapid industrialization was pursued as a goal in itself. A different development strategy emphasizing comparative advantage rather than rapid industrialization would probably have meant a very different outcome.


After over a decade of economic reform, the present economic environment and structure have become greatly different from those of the 1950s. State enterprises and heavy industry have become less important in the economy. The official exchange rate has been repeatedly adjusted to better reflect the market rate; prices of agricultural products have been liberalized; wages have been revised, and other forms of compensation instituted. One of the things that has not been changed is the control of interest rates. Interest rate policy and the accompanying administrative rationing of credit have to be reformed to reflect market conditions -- and the sooner, the better.

When interest rates are allowed to float, the severe business cycles that characterize China's alternation between reform and retrenchment will cease. Floating interest rates will also facilitate the establishment of credit and financial markets that will allocate funds in a more efficient manner to assist China onto the path of stable and sustained growth.

Dr. Justin Y. Lin holds concurrent academic appointments as Associate Professor of Economics at Beijing University, Associate Professor of Economics at the University of California at Los Angeles, and Adjunct Professor of Economics at Australian National University. The above is based on a talk he delivered at the Centre on October 16, 1992.


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