(Reprinted from HKCER Letters, Vol. 25, March-July 1994)
Forum on China: The Awakening Giant
Editor's note: In January of this year, the Western Economic Association International held a Pacific Rim Conference in Hong Kong. This was the first of the association's conferences to take place outside the United States and Canada. One session in the program was a lunch forum co-sponsored by The Hong Kong Centre for Economic Research on "China: The Awakening Giant -- What is Next for Reform and Growth?" The panelists in the forum, in order of presentation, included Dr. Andrew Sheng, Deputy Chief Executive of the Hong Kong Monetary Authority; Professor Justin Yifu Lin of the Department of Economics, Beijing University and Department of Rural Economy, Development Research Center, Beijing; and Professor Steven N.S. Cheung, Head of the School of Economics and Finance, The University of Hong Kong. Dr. Richard Wong, Director of the Hong Kong Centre for Economic Research, served as the moderator. The following is an edited version of the talks given by the three panelists.
Dr. Andrew ShengI would like to present a perspective of how we see China's economic reform in the context of reforms in the so-called transitional socialist economy, i.e., a centrally planned economy moving to a market-based economy. There is extensive literature on this, as you know, covering theories on the big bang approach as opposed to the gradualist approach, etc. But the issue is much more subtle than these approaches suggest. It involves what I call the troika, which comprises budgetary reform, enterprise reform, and banking reform.
These three kind of reforms are interrelated because of the peculiar structure of the centrally planned economy. In a centrally planned economy, both banks and enterprises are owned by the state, so there is a huge moral hazard problem. As we say, "Everything is an iron rice bowl"; enterprises spend money, and the state pays the bills. Worse still, when the economy begins to reform, the problem of macroinstability arises. Where does this instability come from?
As the economy moves towards price reform, state enterprises begin to lose money. As the losses continue and increase, they are financed less by the fiscal budget and more by the banking system. Consequently, the losses of enterprises, which is a quasi-fiscal deficit, begin to show up in the banks' books although the banks do not exactly show it.
Alternatively, this can be put in the following way. The state-owned banking system receives all deposits from the enterprise sector. In a command-type economy, the retail deposits are all put in the national banks, which then lend everything to finance the budget deficit. The result is that, as enterprises begin to lose money under the initial price reform program, the budget also starts losing money: The increasing subsidies for enterprises escalate the budget deficit. The budget finances this through borrowing from the banking system, thus sparking off a huge inflation spiral.
The traditional advice given by economists to reforming economies was to implement monetary policy. However, monetary policy under this type of system is ineffective because the minute the money supply is tightened, interenterprise credit, -- that is, the credit from the surplus enterprises -- to the deficit enterprises, begins to increase. Since the accounting processes and the payment system do not function well, the minute tight monetary policy is imposed, the whole economy is brought down, and production begins to decline much more sharply than it would under a market-based economy.
So, clearly, when the reform process is designed, it has to be a four-point process -- price reform, budgetary reform, enterprise reform, and banking reform, and these have to be very carefully sequenced. I think maybe some of the economists in Eastern Europe have made severe mistakes in underestimating the problems of reform, particularly on the banking side, and have also underestimated the dangers of sharp declines in production arising from premature monetary policy actions. In addition, they have misunderstood the transmission mechanism of monetary policy in relation to the banking system and the interenterprise credit problem.
As for China, I think that up to this point in the reform period, all the above problems have existed in some form. To illustrate , let me present a few statistics. In 1978, 60 percent of the total revenue of China was based on taxation of enterprises. By 1992, this had declined to about 18.8 percent. At the same time, the central budget reimbursement of loss-making enterprises has been very large, probably roughly to the order of about 2 percent of GDP. To the extent that the banking system was able to generate or mobilize a large amount of resources because of the high rate of saving, for the most part that process has not been inflationary.
However, in the 1988-89 period as well as more recently, inflation began to increase. This reflects in part the inefficiencies in the real sector and the difficulties of implementing monetary policy. And, as is well-known, when monetary policy is tightened in a reforming economy, interenterprise credit, which in China is called "triangular debt," increases, because enterprises refuse to pay each other. Therefore, production slows down dramatically, sometimes resulting in the need to pump in more credit than is necessary. When this happens, of course, it sparks off the next round of monetary growth which then leads to potential inflation problems.
What is the role of the banking system in enterprise reform? This is the central issue being debated in countries with reforming economies. One aspect of it, as I think everybody agrees, is that the banking system should not finance the budget in order to bring about macroeconomic stability. It is also agreed that banks should have the role of imposing financial discipline on the enterprises. Clearly, in almost all transitional economies, including China's, the ability of banks to perform this function has been extremely limited. Banks have not had the institutional capacity nor the ownership structure to impose corporate governance. There is a huge debate going on about the role of the banking system. Colin Mayer has talked about whether a country should use the German universal banking system or the Anglo-Saxon banking system whereby banks do not interfere in corporate governance per se, whereas under the German universal banking system, the banks exercise financial discipline on enterprises by owning them as well.
In China, the crux of the problem has been tackled. Firstly, the banks will not be allowed to lend to the budget. The budget has to finance its deficits through bond issues and tax reform. Extensive tax reform has been achieved by moving towards the value-added tax in China.
Secondly, enterprises have not moved towards privatization but towards corporatization; that means forcing enterprises to be more profit-oriented, to meet the market demand, and to respond to market signals.
On the banking side, what has happened under the decisions is firstly the introduction of comprehensive banking laws and the central banking law, to make the Peoples' Bank of China a classical central bank in charge of monetary policy, and secondly to establish policy-based banks to remove the policy-based loans from the specialized banks and install them in policy-based banks, and to force the banks themselves to become more market-oriented and profit-oriented.
This institutional reform, which is being supported by advice from the World Bank, is proceeding gradually and will take a considerable amount of time. So, the banks' ability to impose financial discipline on the enterprises will remain weak for some time to come.
The other major problem in the transformation process during the reform is risk management. This problem which a lot of people have not quite understood is basically as follows: Enterprises in the command economy have infinite gearing; the capital base is almost zero and the debt which is borrowed from both the state and state-owned banks is infinite. So they are extremely vulnerable to financial shocks. That means if any shock occurs, these enterprises literally collapse. In addition, the ability of enterprises at the early stages of the game to respond to interest rate changes is very small. The production love of enterprises will not decrease with rises in the interest rate.
So, the only way to actually stabilize the whole transformation process is to stabilize the financial structures in all three areas. Firstly, on the budget side, one has to stabilize the revenue base and to control expenditures. Secondly, on the banking side, one has to control or improve credit discipline as well as to increase the capital adequacy of banks. Previously, because banks were all state-owned, they did not need high capital adequacy. But in the more volatile price transformation situation, there is the need to increase bank supervision, and to increase the ability of banks to impose credit discipline on enterprises and therefore on their own capital adequacy. Thirdly, one must improve the capital base of enterprises. In this area, there is one fundamental difference between the Chinese reforms and those existing in Eastern Europe, and that is the more rapid development of stock markets in China and also the influence of the Hong Kong stock market through the introduction of the H shares. As most people know, nine Chinese state enterprises have now been allowed to float in Hong Kong, out of which at least six have already been listed. These six have altogether raised about a billion dollars of capital in Hong Kong. Their market capitalization at the end of 1993 was roughly over 2.5 billion dollars. What is effectively happening is that, as these enterprises begin to corporatize and raise capital in the capital market, they reduce their gearing. Moreover, if they quote their shares in, for example, Hong Kong, or internationally, they are subject to better corporate governance because all of the incentive structure is properly in place. Their shares will be subject to flotation rules in Hong Kong, and these enterprises will be subject to international auditing, accounting, and legal standards. The incentive structure will more effectively allow these enterprises to move closer and closer to the market structure. If the enterprises do not deliver, market signals will be sent and their share prices will drop. In general, they will be much more subject to the market process.
In that regard, Hong Kong provides another degree of freedom in the reform process in China relative to that in Eastern Europe. In Eastern Europe, the stock markets have not been very liquid and the legal framework has not moved significantly, and therefore these markets are subject to greater volatility, the same volatility that is seen in the Shanghai and Shenzhen stock markets.
Professor Justin LinChina's economic reform in the 1980s can be called a miracle. Since then, the country has attained an average economic growth rate of about 9.5 percent per annum. For the coastal provinces of Shandong, Jiangsu, Zhejiang, Fujian and Guangdong, the economic growth rate has been about 12 percent. The combined population and area of these provinces is four and five times respectively that of the four Little Dragons of Taiwan, Hong Kong, Singapore and South Korea combined. Human history has never seen such a high growth rate in such a large area with such a sizable population for such a long time. It is really a miracle.
Nevertheless, the Chinese economy has encountered a number of difficulties during the reform process. The first is the recurrence of "boom and bust" cycles, which have become increasingly more frequent and severe. They lead people to wonder whether there is still a chance that China's economy might suddenly collapse. in spite of its overall respectable performance.
The second point of concern is that although the Chinese government has attempted to reform the state enterprise sector at the beginning of the reform, so far the state enterprises have not shown substantial improvement. Currently, about a third of state enterprises incur explicit losses, about another third incur implicit losses, and only about a third make a small profit. Therefore, the state has to subsidize the state enterprises, which has become a heavy financial burden on the government.
Since the reform, as the situation worsens, the percentage of revenues in the national income has declined substantially. Currently, state revenue accounts for less than 20 percent of GNP -- low even for a developing country. This means that the central government does not have the means or the ability to influence economic development in China. In fact, the government even has difficulty paying the police, the army, and other public service groups.
The third area which has caused concern during the reform process is social stability. Although income has been increasing, corruption has also increased substantially. People feel discontented about the social environment, and this may affect social stability.
Can these problems in China's economic reform be overcome? Before we can come up with an answer, we have to investigate the underlying reasons for these problems. In my view, all the problems that China has encountered since the reform have the same source as those with which the country was grappling before the reform.
During the 1950s, China was a capital-scarce agrarian economy, but the Chinese government adopted a so-called forging-ahead policy, with the intention of attempting to accelerate the development of capital-intensive heavy industries in a capital-scarce economy. Capital-intensive heavy industry took a long time to construct, and most of the major equipment had to be imported. On the other hand, since capital was very scarce in China, the interest rate should have been very high. And since China was an agrarian economy, the amount of goods for export was very limited, so foreign exchange should have been very expensive. Also, because of the low income level, there was not much economic surplus. Thus the economic environment did not match the adopted development strategy.
For China to achieve the development goal, the government introduced a set of policies to distort the interest rate, the prices for raw materials, and the exchange rate, to make the development of heavy industries possible.
It is not surprising that this set of policies has resulted in a serious structural imbalance. How could the government guarantee that the limited amount of resources would be allocated to the priority sector, that of the heavy industries? In order to achieve its goal of accelerating the development of heavy industries, it had to introduce a system of administrative resource allocation.
The cost of this kind of macro policy and administrative control system was low economic efficiency due to sectoral and structural imbalance. In the words of the Chinese, "The heavy industry was too heavy, the light industry was too light, and agriculture was neglected." Another kind of inefficiency that resulted was the low incentive to work on the part the workers in the state sectors and the farmers on the agricultural farms.
Beginning in 1979, the Chinese government attempted to improve the efficiency of the economy by relaxing control of the administrative system to provide more incentive to agricultural workers and to allow state enterprises some autonomy in deciding what they wanted to produce and purchase. This effort was very successful. It improved economic incentives and made it possible for resources to be allocated to sectors that had been suppressed in the past, such as labor-intensive light manufacturing industries and non-grain crops. This kind of reform was logical and proved to be effective, because in the past, most suppressed sectors could have put the comparative advantage of the Chinese economy to better use.
Nevertheless, such reform also had its drawbacks because, as it was instituted, the government failed to relax the control on macro policies at the same time. All the initial macro policies were still in effect: Interest rates were still too low, the renmenbi was still overvalued, and there was still a gap between government-planned prices and market prices for raw materials. As a result, all sectors, state and non-state, wanted to compete for the low-priced resources. There were booms in investments as people tried to take advantage of cheap credit, cheap foreign exchange, and cheap raw materials. Also, because the prices were distorted -- there were market prices and government-controlled prices -- all kinds of rent-seeking activities arose.
In the past, all the state enterprises and sectors were tightly controlled. Every dollar used had to be approved. After the reform, the state sector had some autonomy to retain and spend their profits. That is why even though productivity increased, profits declined. Managerial discretion allowed managers and workers to increase wages and fringe benefits more than the increase in the productivity warranted.
With managerial discretion, enterprises chose to compete for cheap resources and invested more under the distorted macro policy environment. An investment boom followed. Bottlenecks in transportation, infrastructure, and construction materials appeared, following the strong demand for resources. Since the government was reluctant to increase the interest rate as a way to check the investment thrust, it resorted to centralized rationing of credit and raw materials and direct control of investment projects. That was the austerity program that was instigated, and which was followed by a bust. This is the mechanism underlying the boom and bust cycle. It is also the reason for the decline in state enterprise profits, as well as the cause of corruption.
In October 1993, the government introduced a whole reform package in a bid to make the macro policy environment more consistent with the liberalized control system. This time it was quite different from the approach in the past. In the past, all the changes were gradual, and they were initiated by farmers, enterprises, and the local government. This time, the package was introduced by the central government, in order to try to eliminate the distortion in the interest rate, the exchange rate, and prices of certain materials. What was the chance that the Chinese government could successfully liberalize the macro policy environment?
The Chinese government has by now realized the importance of the consistency between the macro policy environment, the resource allocation mechanism, and the micro management system. However, these are all endogenous to and induced by the development strategy. If the government still intends to stick to its strategy of accelerating the development of heavy industry in a capital-scarce context, the reform in the macro policy environment and resource allocation system cannot be accomplished. In my reading of the decisions made by the Chinese government, it is my opinion that although the government officials do not mention the heavy-industry-oriented strategy any more, in their thinking it is still there. They still try to protect the old, large- and medium-sized state sectors, which are the remnants of the capital-intensive development strategy. Moreover, the government wants to build more capital-intensive industry in the name of new hi-tech industries which are also capital intensive.
If the interest rate, exchange rate, and prices are determined by the market, all the priority sectors have to go bankrupt. If the government is prepared to support them, the only way is to direct resources to them through distorting the banking system and the price system, and using administrative control to allocate resources. The Chinese government has long been educated to abandon the pursuit of the heavy industry strategy; yet the forging-ahead strategy is politically appealing, not just for China but also for other developing countries.
As such, the future does not seem so bright. But on the other hand, the Chinese government is committed to economic growth. As Deng Xiaoping emphasizes, "The only truth is development and fast growth." The only way to achieve faster growth is to develop the economy's comparative advantage, and the way to benefit from comparative advantage is to allow the market mechanism to work.
Professor Steven CheungIn 1981, I wrote a little pamphlet entitled Will China go Capitalist? and I predicted in no uncertain terms that China would go capitalist. At that time, I was thought crazy by my colleagues. Through the early 1980s, in spite of the 1997 issue of Hong Kong, I remained bullish about China's reform. In 1985, I said in no uncertain terms that there was absolutely no chance that China would go back. Even after the Tiananmen Square episode, Milton Friedman rated me the most bullish person on the subject of China.
I do not agree with the quoted figure of 9 or 9.5 percent growth rate in China since the reform; it is much too low. There is this what I call the "taxation theorem" of income reporting. When there is no tax,as during the Cultural Revolution, there is the tendency to overstate income, but when there is taxation, there is the tendency to understate it. The reported "low" growth rate of 9.5 percent is attributable to the introduction of taxation. I do not know the exact figure, but I think it has to be more than 9.5 percent.
Nevertheless, in the light of the current situation, I have changed my view; my outlook on China is not very hopeful. For some reason, in the last year or so I have become uneasy about the future of China. China's future is bleaker now. For the first time since I have been following the China situation, I find that the Chinese authorities have no idea what they are doing. They are following no general principle. My impression is that China is riding on the great momentum it developed in the mid-1980s and moving towards an uncertain future. I cannot but admit that I am changing my bullish view.
Let me go into some of the theoretical background which leads me to come to this rather pessimistic conclusion. From the standpoint of property rights, in the so-called capitalist society, the rights of an individual are defined in terms of property; that is, it does not matter whether you are good-looking or ugly, intelligent or stupid, kind-hearted or cruel, rights are ranked according to property. But, under the private property system, human rights are equal. You may be richer or own more stocks or businesses, but my human rights are equal to yours. Because human rights are equal, people are equal before the law. With private property rights, therefore, it becomes possible to have a system of jurisprudence, a system in which there is rule of law.
In the communist regime, the property rights of individuals are taken away. It is not that individuals have no rights, but their rights are ranked in terms of hierarchy. As a result, they become unequal in terms of human rights, and they cannot be equal before the law. Somehow when such a society moves to a capitalist system, the hierarchical ranking is gone and replaced by a system which ranks rights in terms of property. The economic reform in China depicts the way in which one system of rights is transformed into another, that is, the system of ranking in terms of hierarchy into the system of ranking in terms of property. That is a very difficult trick to perform.
Between these two systems, there is what I call the Indian system. In this system, both property rights and hierarchical rankings are not well-defined. In India, the prevailing system ranks individuals in terms of their rights to corrupt. The rights can be very well-defined as a result of regulation. When the right to corrupt becomes a system, it will last a long, long time. The grave danger of the Chinese reform process is that it may get stuck in the middle and become another India. In India, the system has not been changed successfully even though the government has spent a lot of effort to do so for years. Sometimes, the situation improves and seems more likely to change, but sometimes it seems less likely.
In fact, a country moving to another rights system encounters a wide variety of difficulties. One of these is the tough resistance by the vested interest groups. Some people have to get hurt, particularly those who are very high up on the old system and who greatly enjoy all its benefits. These people are going to defend their interests and resist. One possible way to get around this is to buy all their rights. The society has already been paying them for years, but unfortunately it seems that the payoff never stops.
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