9
MACROECONOMIC MANAGEMENT OF THE CHINESE ECONOMY SINCE THE 1990s
This chapter aims to identify the pattern of China’s macroeconomic management and explain how macroeconomic policy has been implemented for achieving non-inflationary growth in China.
The Chinese economy’s performance has maintained a cyclical pattern: rapid investment growth, supported by expansionary policy, drives up the economic-growth rate. Inflation follows, so policy is tightened and growth slows. But inflation remains high or rising, so more tightening is imposed. Inflation falls at last, but growth slows more than desired, owing to the overcapacity that resulted from excessive investment in the earlier phase of the cycle. In response, policy becomes expansionary again, and the cycle begins anew: led by investment growth, the economy rebounds.
The chapter reviews briefly China’s macroeconomic management since the early 1990s. Based on this review, the chapter goes on to discuss the question of how monetary policy, fiscal policy and exchange rate policy are used to achieve the objectives of growth and price stability in China, respectively. The chapter ends by concluding that while on the whole China’s macroeconomic management over the past two decades is successful, how to strike a balance between short-run macroeconomic stability and long-run structural adjustment is still a big challenge facing China.
Over the past three decades, China succeeded in achieving an average annual growth rate of slightly below 10 percent while having maintained an average annual inflation rate of less than 3 percent.
China’s high growth potential is attributable to rapid capital accumulation supported by a very high savings rate, abundant supply of skilled workers and engineers, and sizable improvement in total factor productivity (TFP). China’s economic reforms have played an important role in the rise of TFP (Perkins, 2005: 4).
However, China’s growth over the past three decades was by no means smooth. The economy constantly suffers from overheating and sluggish growth in tandem. Given the scale of the growth potential, the government has to manage the demand side of the economy to achieve full utilization of the potential, iron out cyclical fluctuations, and offset the impact of external shocks.
China has become a market economy after a thirty-year transformation. However the transformation is not fully complete yet. State-owned enterprises and local governments remain key players in China’s economic activities. State-owned commercial banks continue dominating the financial market. Financial liberalization is still in progress. As a result, while China’s macroeconomic management shares the fundamental characteristics of a typical market economy, it has its own features.
This chapter aims to identify the pattern of China’s macroeconomic management and explain how macroeconomic policy has been implemented for achieving non-inflationary growth in China. The chapter is organized as follows. The first section is a brief review of China’s macroeconomic management since the early 1990s. The second section is devoted to discussing how monetary policy is used to achieve the objectives of growth and price stability. The third section is about China’s fiscal policy. The fourth section discusses China’s exchange rate policy. The final section presents concluding remarks.
Starting from the early 1990s, China’s macroeconomic development can be divided into five major periods: 1990–1997, 1998–2002, 2003–2008, 2008–2010, and 2010 to the present. The division above is not entirely based on economy cycles China has experienced; rather it is based on the occasions when difficult decisions were made to alter the direction of macroeconomic policy.
At the beginning of the 1990s, the Chinese economy was in a poor condition. Though the inflation rate had fallen as a result of China’s anti-inflation campaign in the late 1980s, GDP growth was just 4.1 percent in 1990, the lowest rate since 1978.
Deng Xiaoping’s call for speeding up reform and expansion of the “opening up” in his famous tour to southern China in the spring of 1992 dispelled any lingering doubt among the public about the future direction of the Chinese economy. Facilitated by a spurt in money supply and credit, investment surged at astonishingly high rates of 42.6 percent in 1992 and 58.6 percent in 1993. As a result, China’s GDP growth rate shot up to 14.2 percent and 13.5 percent in 1992 and 1993, respectively. Following the strong growth, inflation in 1992 rose to 6.4 percent, and in 1993 it rocketed further to 14.7 percent.
The investment fever in this period in turn was attributable to the investment fever in real estate development, which grew at breath-taking speeds of 93.5 percent in 1992 and 124.9 percent in 1993. Being concerned with inflation and the dire consequences of a burst of real estate bubbles, in August 1993 Zhu Rongji, as Governor of the People’s Bank and Vice Premier, took drastic action to clamp down on real estate investment by cutting credit growth, among other measures. He even went as far as sacking local officials who failed to rein in local bank lending.1 The growth rate of money supply started to fall rapidly.
Though the growth rate of money supply fell, with a delayed effect inflation peaked at 24.1 percent in 1994, the worst on record since 1979. The causes of the continuous rise in inflation were multi-fold, and included the administrative adjustment of prices aimed at rationalizing the price structure, a very large increase in grain prices due to supply shortages, a temporary increase in transaction costs because of the restructuring of the grain circulation system, and an increase in foreign exchange reserves thanks to strong capital inflows. However, according to Zhu Rongji, the fundamental reason was still the investment fever in infrastructure and real estate development.2
Faced with worsening inflation, the government continued the tightening of money supply further in 1995.3 In 1996, the excess supply of manufacturing goods became ubiquitous and inflation continued to fall precipitately from the 1994 peak. In 1996 the People’s Bank of China (PBOC) cut interest rates on loans and deposits for the first time since 1993.
In 1997, the growth rate of real GDP as well as the inflation rate fell continuously. The rapid deterioration of the economic situation and the gloomy global economy prompted the government to cut the interest rate on loans and deposits in October again, sending a strong signal of policy change from tight to “accommodative.” However, despite the intention of loosening by the PBOC, both the growth rates of money supply and credits fell precipitately in 1997. By the end of 1997, the growth rate of GDP and the inflation rate fell to 8.8 percent and 2.8 percent, respectively.
In 1998, due to the impact of the Asian crisis, China’s export growth dropped drastically and then, with some lag, investment growth also dropped commensurately. Despite the further loosening of monetary policy, China’s growth rates fell to below 7 percent in the first half of 1998. An important phenomenon in 1997–2001 was that despite the PBOC cutting the reserve requirement ratio from 13 percent to 8 percent and having lowered benchmark interest rates six times since, the growth rates of money supply and credit continued to fall and only bottomed out at 13 percent and 11 percent in the last quarter of 2001.
In response, and after some hesitation, the government turned to expansionary fiscal policy (“proactive fiscal policy”) in the second half of 1998. Expansionary fiscal policy proved effective. China achieved a growth rate of 7.8 percent in 1998. But the inflation rate fell to −0.8 percent. It was the first time in history that the inflation rate over the course of a year became negative.
The PBOC’s policy initiatives taken during the period of deflation to encourage the expansion of mortgage loans started bearing fruit in 2000. Investment growth in real estate development rebounded strongly from negative in 1997 to 13.7 percent in 1998 and rose further to 21.5 percent in 2000. These trends played a pivotal role in the improvement in the growth outlook that year.
The growth of the Chinese economy has accelerated since the second half of 2002. Again, this was led by strong investment growth, which was partially a response to the ubiquitous “bottlenecks” resulting from lack of investment in infrastructure and many key industries since 1997. By this time GDP growth returned to 9.1 percent.
Growth momentum, led by the investment boom since 2002, was maintained and became increasingly evident in 2003. Again, the strong growth of real estate investment was the single most important contributing factor to the growth of total investment and hence that of GDP.
In October 2003 the PBOC raised benchmark interest rates for the first time since 1997. It showed that macroeconomic policy had shifted from loosening to cautious tightening. Efforts were also made to shift fiscal policy towards a more neutral stance.
Despite the shift in monetary policy, investment fever continued unabated. In response, the government not only tightened macroeconomic policy further but also resorted to various administrative methods once more. Throughout 2004, growth of money supply and credit fell rapidly to 13.5 percent and 10.9 percent in October 2004, respectively.
In early 2005, due to the strong investment growth from 2002 to 2004, signs of overcapacity became prevalent and profitability of the enterprises fell significantly. It seemed that the rebound in the economy that began in 2002 had come to an end. Some economists started to advocate the shift of policy direction from “moderate tightening” to loosening. However, the expected slowdown of the economy failed to materialize in 2005. At the same time, the growth rates in the money supply and credit rebounded from relatively low levels of 2004. Overcapacity was absorbed temporarily by the creation of new capacity and rapid increase in exports. In fact, exports grew at an astonishing rate of 220 percent in 2005, which was attributable partially to the prevalent overcapacity in the domestic market. As a result, the PBOC was able to decide to de-peg the renminbi from the US dollar, and allowed the renminbi to appreciate by 2.1 percent in July 2005.
Despite prevalent overcapacity, growth momentum was unexpectedly strong in 2006. The growth rate of investment accelerated, while net export growth maintained a high rate of 41.4 percent.
The robustness of the economy in 2006 was commonly attributed to the fact that 2006 was the first year for the implementation of the eleventh Five-Year Plan and the last year before the leadership change in provincial governments. Local authorities and enterprises were very keen on putting up good performances and positioning themselves for future development by increasing investment in their respective localities as much as possible.
Because the central bank was reluctant to allow the renminbi to appreciate more speedily, the large current account and capital account surpluses created abundant liquidity. How to mop up the excess liquidity became a hot topic in 2006. A puzzling phenomenon in 2006 was that despite the abundance of liquidity, the inflation rate was very low until the second half of 2006. In hindsight, the low inflation rate can be explained by rising asset prices. Large amounts of money were attracted to the real estate market and hence reduced inflationary pressure on goods and services. In 2006 the economy grew at 12.7 percent, while inflation was just 1.5 percent.
After five consecutive years of high growth since 2003, red lights suddenly started to flash in the second quarter of 2007. Thanks to favorable internal and external conditions, China’s share price index, which had been in the doldrums for years, began to increase gradually in 2006 and then exponentially. It took eighteen months for the Shanghai composite share price index to rise from 2,000 to 3,000 points and then just another thirty-one working days for it to rise from 3,000 to 4,000 points. After soaring to more than 6,200 in October 2007, it crashed. Until then China’s share price index was still languishing at just under 2,500 points.
Since the fourth quarter of 2006, inflation was steadily worsening. Initially, the increase in CPI was caused almost exclusively by food prices, especially by pork prices. Therefore, many economists and government officials argued that, as soon as piglets matured, the supply of pork would increase and pork prices would fall, along with CPI. However, inflation continued to worsen unabated throughout 2007 and until February 2008, though the pork price had peaked in August 2007.
Despite the fact that the PBOC raised reserve requirements, increased benchmark interest rates five times, and even imposed quantitative limits on bank lending, the economy sustained strong growth and inflation continued to worsen. The high growth rate of GDP in 2007 was on par with the historical record registered in 1992.
In February 2008, the annualized growth rate of CPI reached 8.7 percent, the highest in eleven years, while signs of the weakening of the economy were becoming more evident.
Before the Chinese government was able to decide whether it should tighten monetary policy further or not, the US subprime crisis struck. The consequent dramatic slowdown of the global economy hit the Chinese economy very badly. Following the free fall in the global economy, Chinese economic growth fell to 6.8 percent in the fourth quarter of 2008, the lowest annualized quarterly growth rate in decades, because of dramatic falls in exports. In fact, the growth rate of exports fell from 20 percent in October to −2.2 percent in November, and extended further, because the share of exports in China’s GDP was 36 percent in 2007. The impact of the fall in exports on growth of GDP was bound to be huge. Following the fall in GDP growth, inflationary pressure disappeared suddenly and became negative in February 2009; house prices in some major cities and share price indexes fell precipitously.
The Chinese government reacted very quickly. In September 2008, the PBOC loosened monetary policy and renminbi appreciation was stopped. Much more importantly, the government introduced a 4,000 billion yuan (US$580bn, €404bn, £354bn sterling) stimulus package for 2009 and 2010 in November 2008.
In response to extremely expansionary monetary and fiscal policy, the Chinese economy rebounded quickly to 7.9 percent in the second quarter of 2009. Fixed asset investment growth was 30.5 percent in 2009, and contributed 8 percentage points to the overall growth that year. Inflation returned to positive in November 2009.
Despite the success in achieving a V-shaped recovery, the rescue package and excessive expansionary monetary policy also produced serious negative side effects. To launch a large number of projects in a very short time span inevitably would lead to serious waste and deterioration of investment efficiency. Asset bubbles and inflation also reemerged.
In the first quarter of 2010, China’s growth rate peaked at 12.1 percent, while inflation continued to rise from a low level. To rein in housing bubbles and preempt the worsening of inflation, in January 2010, the PBOC raised the reserve requirement for the first time since the middle of 2008. This was subsequently repeated five times and benchmark interest rates on deposits and loans were hiked twice in 2010. At the same time, both the growth rates of credit and broad money fell significantly. The growth rate of GDP and the rate of inflation in 2010 were 10.3 percent and 3.3 percent, respectively. In the last quarter of 2010, the inflation rate rose to 4.6 percent.
It was expected that China’s inflation situation would improve in early 2011, because of the changes in the direction of monetary and fiscal policy. However, inflation failed to fall, due to the rise in commodity prices in early 2011. The government tightened monetary policy further by raising reserve requirements and benchmark interest rates on deposits and loans in June. Inflation started to fall after having hit the three-year high of 6.5 percent in July 2011.
While the vigorous liquidity tightening eventually mitigated inflationary pressures, it put the brakes on economic growth. In fact, economic growth had been slowing continuously after it peaked in the first quarter of 2010. In the last quarter of 2011, the growth rate fell to 8.9 percent. More importantly, in the last month of 2011, growth rates of total investment, real estate investment, and manufacturing investment all fell. Home sales fell by 8 percent and housing starts fell by 18.3 percent. Due to the worsening of the global environment, China’s exports also performed poorly.
Therefore, despite the fact that China’s GDP growth rate for 2011 was still as high as 9.2 percent, concern about a hard landing for the Chinese economy was on the rise. The PBOC lowered the reserve ratio in November 2011 and signaled the change of policy direction from tightening to loosening.
Most economists in China expected that China’s growth would rebound in 2012. But the performance of the Chinese economy in 2012 since the second quarter of the year has been disappointing. This is attributable to three factors. First, the direct and indirect impact of the decline in growth of real estate investment on the economy was stronger than expected. Second, the European sovereign debt crisis had been worse than expected. A more fundamental cause is that in order to achieve sustainable development and shift priorities from growth to transforming the economic development patterns and restructuring the economy, the government refrained from ushering in new policies to stimulate the economy. By May 2012, however, the government changed its mind, with the National Development and Reform Commission approving 7 trillion renminbi (US$1.3 trillion) in new projects. That, together with one ensuing reserve ratio cut and two benchmark interest-rate cuts by the PBOC, guaranteed an end to the economic slowdown in the third quarter of 2012. However, because the pickup of the economy was once again led by investment growth, the recovery of the growth momentum perhaps will leave more problems to be resolved in the future.
Since 1979, the structure and functions of the Chinese banking system have been gradually reformed. In 1984, the PBOC was restructured as a central bank and its commercial banking functions were transferred to four specialized banks.
The PBOC established the first unified national interbank lending market in January 1996. A reserve system was established in March 1998, when the required reserves account and excess reserves account were merged by the PBOC. All reserves that banks deposited with the PBOC would be paid a unified interest rate. After the merger, the required reserve ratio was set at 8 percent, a fall of 5 percentage points from before the reforms. As of 2012, the ratio is 20 percent. In December 2003, the interest rate on required reserves and excess reserves was set at 1.89 percent and 1.62 percent, respectively. In March 2005, the latter rate was lowered to and remains at 0.99 percent.
China’s money market consists of the interbank loan market, the bond repurchase market, and the bill discount market. Its capital market comprises the bond market and the stock market. The interest rate in the interbank loan market, the China Interbank Loan Offered Rate (CHIBOR), is calculated and reported according to interbank loan interest rates determined by the supply of and demand for loans by twelve commercial banks and fifteen financial centers on each working day. The PBOC’s interest rate on bank reserves and that on relendings set the ceiling and floor respectively for the CHIBOR. The interest rate in the bond repurchase market, Repurchase Offered Rate (REPOR), is the market rate determined by the supply of and demand for government bonds. The Shanghai Interbank Offer Rate (SHIBOR) was introduced in January 2007, which is calculated as an arithmetic average of offered rates for interbank loans by sixteen participating banks, and fixed at 11:30 a.m. on each working day. SHIBOR is similar to LIBOR, with the aim of becoming China’s benchmark interbank interest rate.
China’s financial system is still dominated by banks. In 2011, bank loans accounted for 75 percent of total “social finance,” while bond and equity issues accounted for 10.6 percent and 3.4 percent, respectively. In the same year, government bonds, financial bonds, enterprise bonds, and central bank bills accounted for 35.49 percent, 32.82 percent, 22.32 percent, and 9.36 percent of total bond issuance, respectively.
Since 1978, China’s monetary policy has undergone various changes in terms of objectives, intermediate targets, and instruments.
According to the official version, the final objective of monetary policy is “to maintain the stability of currency value and thereby promote economic growth.” The stability of currency value means that both price stability and the stability of the exchange rate of the renminbi should be maintained.4 In fact there are at least three final objectives in China’s monetary policy: growth, price stability, and exchange rate stability. To harmonize these three objectives is by no means an easy job. In practice, the number one final objective is to guarantee a minimum growth rate of 7 percent. The second final objective is an inflation rate of around 3 percent, which is defined as a medium-term average rather than as a rate (or band of rates) that must be held at all times. The final objective is to maintain the stability of the exchange rate of the renminbi that once was pegged to the US dollar and now enjoys some degree of volatility but still refers to a basket of currencies.
China’s experience shows that the trade-off between growth and inflation exists. To raise growth, policy makers need to accept a higher rate of inflation; to lower inflation, the PBOC has to allow growth to fall. Normally, changes in inflation follow those of growth. The complication lies in the variation in the time lag between growth and inflation in each economic cycle. Hence to get the timing right is very difficult.
As for exchange rate stability, due to the PBOC’s ability to carry out large-scale sterilization operations and the existence of capital controls, the PBOC is able to achieve growth and inflation objectives without being constrained too much by exchange rate considerations. However, in some circumstances, because of the difficulty in fully sterilizing excess liquidity, the maintenance of exchange rate stability is bound to weaken the dependence of monetary policy. On the other hand, when the PBOC is considering tightening monetary policy, it has to consider the impact on the exchange rate. In short, due to various constraints in the sense of Tinbergen’s rule that the number of policy instruments must be equal to the number of available policy instruments, conflicts among these three objectives are inevitable.
In the third quarter of 1994, Chinese monetary authorities formally took the supply of broad money (M2) rather than its counterpart – total bank credit, as the intermediate target of monetary policy.
Although the growth rate of money supply is officially the intermediate target of monetary policy and the PBOC sets a target for the growth rate of money supply each year, it has never strictly adhered to such a target in practice. The target is just a policy manifestation, a reference target. More often than not, the PBOC fails to hit the target. First, whenever the inflation rate had surpassed certain thresholds, irrespective of the growth rate of money supply, it will tighten monetary policy. On the other hand, whenever the growth rate of the economy falls below certain thresholds, irrespective of the growth rate of money supply, it will loosen monetary policy. Fortunately, over the past thirty years, China has never come across a situation where inflation is very high and the growth rate is very low simultaneously. Second, when the economy suffers from serious overheating or deflation, the PBOC tends to return to credit controls via “moral persuasions.” To put it more bluntly, the PBOC would ask commercial banks directly to reduce or increase credit to enterprises and households and without exception, commercial banks will duly comply with reluctance. In fact, each year in recent years, the PBOC will set a target for the increase in credit for the year. Third, in recent years, due to the burgeoning of financial innovations, various kinds of near-money are supplementing traditionally defined money to play the role of medium of exchange and store of value. Hence, the usefulness of keeping M2 as the intermediate target is becoming more and more questionable. The PBOC also used in recent years the so-called “total social finance” that includes all forms of finance as a reference target.
In developed countries, until recently changes in interbank interest rates create cascading effects on the interest rate structure of the entire financial system and eventually influence the real economy. In China, because of the fragmentation of the money market and control over interest rates on loans and deposits, changes in interbank interest rates cannot have the same effect. Hence, the PBOC’s open market operations (OMOs) are aimed mainly at influencing money supply rather than the key short-term interbank interest rates such as CHIBOR, SHIBOR, and the repo rate.
The PBOC initiated OMOs in May 1996. The operational target of OMOs is the level of bank deposits with the PBOC. Trading between the PBOC and primary dealers consisting of forty commercial banks takes the form of the repurchase of government bonds or central bank bills (CBBs). The maturities of repurchases (reserve repurchases) are divided into three time spans: seven days, fourteen days, and twenty-one days. The prices of the traded bonds and bills are determined by offering and bidding. The transactions between the central bank and the commercial banks are conducted via a computerized trading network managed by the PBOC.
Because of the persistent increase in current account and capital account surpluses and the PBOC’s reluctance to allow the renminbi to appreciate, increase in foreign exchange reserves became the single most important, if not the only, source of increase in the monetary base. To control the expansion of the monetary base, the PBOC sells its assets continuously to sterilize the increase in base money. In the beginning, cash bond trading was the most common means of adjusting the monetary base. It was replaced by government bond repo transactions later. The PBOC sold all government bonds with which repos had been conducted quickly. Since May 2003, it has conducted OMOs via CBB repo. In other words, the OMOs in China are basically sterilization operations. Changes in base money are equal to changes in the gap between the base money created by increase in foreign exchange reserves and the base money that has been sterilized through selling CBBs by the PBOC.
Besides OMOs, in its toolkit, another important instrument used by the central bank to change the money supply is the required reserve ratio. In quantitative terms, changes in multiplier rendered by changes in the reserve ratio have the same effect on the money supply as changes in the monetary base for a given multiplier. Hence, when the reserve ratio is increased by a certain number of basis points, it can be said that a corresponding amount of liquidity is frozen. In short, by changing the reserve ratio, the PBOC is able to control money supply through changing the money multiplier.
In a typical market economy, the central bank will refrain from changing the required reserve ratio as much as possible, because the measure is regarded as too drastic and clumsy. However, in China the adjustment of the reserve ratio is often regarded as a more powerful and cheaper monetary instrument than OMOs. Since 1998, the central bank has changed the required reserve ratio forty-two times in total. As of the end of 2012, the required reserve ratio stands at 20 percent.
Despite the progress in interest rate liberalization, due to the fragmentation of China’s money market and the abundance of liquidity in the banking system, there is no benchmark interest rate in China equivalent to the Fed Funds rate in the US, the base rate in the US, and the overnight call rate in Japan.
The benchmark interest rates the PBOC administers are the one-year lending rate and the one-year deposit rate. Although changes in the benchmark lending and deposit rates cannot influence the entire interest rate structure of the economy in a cascading manner, changes in the benchmark interest rates can affect real GDP and inflation through its influence in the financial costs of enterprises and, to a certain degree, household saving behavior. Chinese enterprises have rather high leverage ratios, probably above 100 percent currently. The changes in the benchmark lending rate will influence the profitability of enterprises, and hence influence investment and production decisions. The interest rate spread between deposits and loans is an important source of revenues for commercial banks. Hence, changes in the benchmark interest rates will also influence the behavior of commercial banks and other financial institutions. Changes in the benchmark lending and deposit rates also influence real GDP and inflation via their influence in household investment and saving behavior. Furthermore, changes in the benchmark interest rate have important announcement effects.
While continuing to use the one-year deposit rate and lending rate as benchmark interest rates, the PBOC has been increasing the freedom of commercial banks in deciding their interest rates. Now only a ceiling on the deposit rate and a floor on the lending rates remain. In June 2012, the PBOC further announced that commercial banks could raise their deposit interest rates up to 110 percent of the benchmark deposit rate. Up until then commercial banks could lower their one-year lending rates to no more than 90 percent of the benchmark-lending rate.
Despite financial liberalization, when the economy suffers from overheating, the PBOC often resorts to the annual bank-by-bank caps on credit growth, and uses official “window guidance” to influence the bank lending; when the economy suffers a serious slowdown, the same measures will be used to “persuade” commercial banks to increase their loans. Without exception, when moral persuasion is applied, commercial banks would obey, regardless of their business conditions. The reason is simple: all major banks are state owned and the governors of the major banks are officials with the rank of deputy minister.
The majority of empirical studies show that there is a strong correlation between money supply, real GDP, and inflation in China. However, causalities among them are complicated. The complication is caused mainly by two problems.
The first problem is about the exogeneity of money supply, which is conditional on the exogeneity of the monetary base and stability of the multiplier. In China the two conditions for the exogeneity of money supply cannot be met entirely. The expansion of China’s monetary base comes overwhelmingly from the increase in foreign exchange reserves. The PBOC sells CBBs to offset the influence of the increase in foreign exchange reserves on the monetary base. Due to all sorts of complications, it is difficult for the PBOC to control the size of the monetary base as it wishes. Furthermore, the monetary multiplier is unstable, because commercial banks can hold more or less the level of reserves than the PBOC deems satisfactory. When the economy is in deflation, the monetary multiplier tends to fall, because of banks’ reluctance to lend and hence the resulting rise in banks’ reserves. For example, during the 1998–2001 period of deflation, not only was base money released in 1998, but also the banks’ reserve requirement was lowered in 1999, yet growth of money supply still declined continuously and credit growth similarly fell until the end of 2001.5 Conversely, when the economy is overheating, the multiplier tends to increase. When the PBOC raises the reserve requirements, commercial banks can satisfy this increased reserve requirement simply by reducing its excess reserves, without cutting credit.
The second problem is the time lags between changes in the money supply and changes in real GDP growth and inflation. When the economy is below full employment, changes in the quantity of money alter the level of output rather than prices. Normally, the increase in money supply will lead immediately to the increase in investment, because state-owned enterprises, which still dominate the economy, have unsaturated appetite for investment; as long as credit is available, they will increase investment. The increase in investment and the resulting increase in the income level will create a second-round increase in growth via the increase in consumption demand. When the economy reaches full capacity, faced with an inflation rate higher than the implicit target, the monetary authority will tighten money supply. Mainly due to the unavailability of credit, investment demand will fall and so will growth. Overcapacity will put pressure on the price level and inflation will fall several quarters after monetary tightening. It is common in periods of monetary tightening that while growth has been falling, inflation is still high. To tighten or not to tighten is a difficult decision for the monetary authority to make. It is also common in periods of monetary loosening that while the economy is growing at a rate higher than the trend rate, inflation is still low.
It is worth noting that under certain circumstances, the transmission from the money supply to real GDP and inflation can fail to work. For example, during and in the wake of the Asian financial crisis, despite the fact that the growth rate of M2 is significantly higher than that of nominal GDP, both real GDP and inflation refused to budge. The growth rate of money supply was much higher than that of credit. This situation is attributable to the credit crunch as banks feared for the safety of their loans, as well as higher demand for the real balance by households and enterprises during a bad time.
The burgeoning of the capital market caused another important complication. The rise in asset prices will increase the demand for money. As a result, even though the growth rate of money supply is much higher than that of nominal GDP, inflation can be moderate. The low inflation rate makes the monetary authority complacent. As a result, asset bubbles will get worse and burst eventually with all their dire consequences.
Despite the fact that the growth in quantity of credit and that of broad money M2 is highly correlated, there is a great temptation for the PBOC to jump the gun to instruct or “persuade” state-owned commercial banks to increase or decrease credit extended to enterprises. China did not suffer a serious credit crunch and liquidity shortage, when the global financial crisis struck. The reason is simply that the PBOC instructed commercial banks to increase their credit to enterprises to accommodate the government’s stimulus package, and commercial banks duly complied. However, the direct intervention by the PBOC on commercial banks’ lending activities certainly will create serious distortions in the economy.
All in all, despite the complications, money matters in China. Changes in money supply will eventually lead to changes in real GDP and inflation, though with various lags that are difficult to predict. Some empirical studies have shown that there are stable econometric relations between money supply, prices and output. Since this chapter is devoted to historical and institutional description and analysis of macroeconomic policy, quantitative relations are not discussed here.
Before 1994, despite the high growth rate of the Chinese economy since reform and opening, the Chinese government’s fiscal position was very weak. Both the share of total government revenues in GDP and that of central government revenues in total government revenues were very low. The extremely weak fiscal position seriously weakened the government’s ability to exercise macro control over the economy (Wang and Hu, 2001). To strengthen the central government’s fiscal position, China introduced fiscal reform in 1994. The aim of the reform was to establish a tax-assignment system, which was called the revenue-sharing system (fenshui zhi). Under the new system, revenues were shared between the central and provincial governments. Taxes were divided into three categories: central, local, and shared. The central taxes included tariff, consumption tax, and value-added tax on imports, vehicle purchase tax, and cargo tax. These tax revenues would go into the central coffers. The local taxes that would go into local budgets included urban maintenance and development tax, tax on contracts, resource tax, tax on the use of arable land, urban land using tax, and agriculture tax. Shared tax included value-added tax, business tax, stamp duty on securities transactions, personal income tax, and enterprise income tax. Among all taxes, in terms of magnitude, the value-added tax was by far the single most important tax. The tax rate of value-added tax on most products was 17 percent. Among the value-added tax collected, 75 percent would go to the central government, and 25 percent to local government. Other important taxes included enterprise income tax and business tax. The tax rate on enterprise income was 33 percent, and among the tax collected 30 percent goes to the central government and 3 percent goes to local governments. Local administrations were responsible for the collection of the enterprise income taxes on local firms, while the State Administration of Tax was for the others.
There have been some more incremental reforms since 1994, including a conversion of the value-added tax to the standard sales tax; rationalization and consolidation of the corporate income tax; abolishment of agricultural tax, and moving the responsibility of collecting personal income tax to the State Administration of Tax; equalizing foreign enterprise income tax rate to 33 percent, and experimenting with property taxes in a few cities.
The 1994 reform eventually led to a significant improvement in the central government’s fiscal position. In 2000, China’s national fiscal revenues rose to 1339.5 billion yuan, a 17 percent increase over 1999. This trend continued thereafter. The tax revenues grew persistently by double digits. In 2007, before the global financial crisis struck, tax revenues increased by an astonishing 27.56 percent over the previous year. Because the national fiscal revenues had grown much faster than GDP every year over a decade, the share of the national fiscal revenues in GDP increased to 20.57 percent in 2011, compared with 10.83 percent in 1994. The rapid increase in tax revenues, which constitute the bulk of government revenues, was attributable mainly to the high growth rate of GDP under the new tax regime, and the vastly improved tax collection.6
China’s national fiscal revenues consist of central government revenues and local government revenues. The most important sources of central government revenues are value-added tax, enterprise income tax, non-tax revenue, and business tax. It is worth noting that export tax rebate is one of the most important items that subtract the government revenues. Land value added tax and arable land use tax are two very important resources of local government revenues.
China’s national expenditures consist of central government expenditures and local government expenditures. The top ten central government expenditures are central government revenue transfer to local governments, national defense, agriculture, forestry and water affairs, social security, communication and transportation, education, science and technology, interest payment on public debt, social housing, energy conservation and environment protection, and public security.
Local governments bear large shares of fiscal expenditures in government administration, social security, education, science and technology, agriculture, forestry and water affairs, medical care and sanitation, communication and transportation, social housing, and so on.
In developed countries, in the short run, the built-in stabilizers within fiscal systems can smooth the variations in demand in a counter-cyclical way in support of or supplement to monetary policy to achieve given growth and inflation targets. There are built-in stabilizers in China’s fiscal system. However, because of the extremely low shares of personal and enterprise income tax revenues in GDP, which until 2011 were just 1.3 percent and 3.6 percent, respectively, the role of taxes in automatically stabilizing the economy is virtually non-existent. The same is true of government expenditures. The most important stabilizer in the spending side is government expenditure in social security and employment, which accounted for just for 2.36 percent of GDP in 2011.
The functions of the Chinese government’s budget include:
• the maintenance of the smooth running of government administrations;
• the provision of public goods and services;
• narrowing the income distribution gap between regions and social strata;
• support of reform and economic transition by providing necessary financial support; and
• investment in capital construction.
Usually, the government would refrain from changing government revenues and expenditures as policy instruments to stimulate growth or contain inflation. In other words, China’s fiscal policy has been neutral or moderately expansive for most of the time since the 1990s. The government adheres to the principle of “calculating how much revenues received before deciding how much to spend.” Over the past decades, China’s budget deficit-to-GDP ratio has mostly been kept below 3 percent, and hence, China’s public debt-to-GDP ratio is still about 20 percent at this moment.
Only when the economy is in deflation or falling dramatically and monetary policy is impotent or would take too long to deliver results, will the government use very expansive fiscal policy to boost or stabilize conditions. Since the early 1990s, there have been only two occasions when China tried to spend its way out of trouble. One was in the second half of 1998 when the government under Zhu Rongji implemented expansionary fiscal policy during the Asian financial crisis; another was during the 2008–2009 global financial crisis when the government under Wen Jiaobao ushered in a very large stimulus package.
In the first episode, the Ministry of Finance sold 100 billion renminbi bonds to commercial banks to raise money to fund investment in infrastructures. At the same time, commercial banks were instructed to extend another 100 billion renminbi loans to supplement the government financing of infrastructure investment.
In the second, the government introduced a 4,000 billion yuan (US$580 billion, €404 billion, £354 billion sterling) stimulus package. The prescribed dosage of the stimulus was very large, at 14 percent of GDP in 2008. To support the fiscal expansion, with the PBOC’s moral persuasion, commercial banks extended 9.6 trillion renminbi loans, an astronomical figure China had never seen before in history
China’s experience shows that expansionary fiscal policy is very effective in stimulating economic growth when the economy is operating below capacity. When the economy is overheating or under the threat of asset bubbles, the government usually will rely on monetary tightening to rein in the economy; the fiscal measures such as raising stamp duty and property taxes are used scantly and only in a very modest manner.
One of the most important features of China’s expansionary fiscal policy is that the Chinese government is very conscientious in using market mechanisms to ensure that public money will be used more efficiently. When the government has decided to support a certain project, it will finance it only partially. The contractors, whoever they are, have to find the bulk of the finance themselves in financial markets, and subject their projects to the scrutiny of market forces. During the 2008–2009 fiscal expansion, though the central government was responsible for approvals of all major investment projects, among the 4 trillion yuan stimulus package, only 1.2 trillion yuan came from the central government’s coffers. To fill the funding gap, local governments were encouraged to create “local financing platforms,” a sort of special purpose vehicles, to borrow from banks with future government revenues or land as collateral to finance the investment projects packaged in their localities. They were allowed to issue local government bonds, but the issuances were done by the central government on their behalf. With a very loose credit policy implemented by the PBOC and obedient commercial banks, local governments were able to raise 10.7 trillion yuan, of which 79.1 percent was in bank loans.
Because of the adoption of expansionary fiscal policy to fight deflation during the Asian financial crisis, China’s budget deficit increased from a meager 0.78 percent of GDP in 1997 to 1.16 percent in 1998. Because of the increase in budget deficits, though moderate, the debt-to-GDP ratio increased from 10 percent in 1998 to 13.8 percent in 2000. The government shifted to a more neutral fiscal stance in 2003, and as a result budget deficit fell continuously. In 2008, China even ran a budget surplus of 0.58 percent. As a result, China’s public debt-to-GDP ratio increased only slowly. In 2008, China’s debt-to-GDP ratio was about 20 percent. In 2009, because of China’s extremely large stimulus package, its budget turned to negative. In 2010, the budget deficit peaked at 2.8 percent of GDP. In 2012, the ratio is expected to fall back to less than 2 percent and China’s public debt-to-GDP ratio will still be maintained at relatively low levels.
Since April 1991, China’s official exchange rate regime shifted from fixed exchange rates to a managed float. The official renminbi exchange rate fluctuated much more frequently, but devalued for the most of the time until 1994. At the beginning of 1994, the official and swap markets were merged. The official rate fell from 5.80 yuan per dollar to 8.70 yuan per dollar upon completion. Because a large proportion of foreign exchanges had already been traded in the swap market before the merger, the impact of the large devaluation of the official exchange rate in 1994 on China’s trade was not very significant. Between 1994 and 1997, China’s exchange rate regime was supposed to be “a unified, managed, floating exchange rate system.” Under this system, the central parity was set solely against the US dollar with a small band, and the central parity was allowed to crawl. During this period of time, the renminbi nominal exchange rate appreciated by 4.5 percent, because of the increase in China’s international balance-of-payments surplus. In 1996, the renminbi was made convertible for current account transactions.
After the outbreak of the Asian financial crisis in 1997, China shifted to a de facto peg to the US dollar. With the help of capital controls, the firm commitment of “no devaluation” enabled China to come out of the Asian financial crisis relatively unscathed.
Since 2003, the US government started to press China to appreciate the renminbi. In July 2005, China gave up the peg to the dollar and returned to managed floating. At the same time, the yuan’s exchange rate against the dollar appreciated from 8.28 yuan per dollar to 8.11 yuan per dollar, an appreciation of 2.1 percent.
The new exchange rate regime is characterized by the so-called “referring to a basket of currencies.” According to the PBOC, the yuan’s closing rate against the dollar at the end of each business day was to become the central parity rate for a trading band on the following day. The yuan would be allowed to fluctuate up to 0.3 percent plus/minus the central rate against the dollar each day. It is worth noting that the renminbi exchange rate is not strictly pegged to a basket of currencies. The basket is just a reference: the yuan’s central parity against the dollar still can be decided at PBOC’s discretion. It seems that in the daily determination of the yuan’s exchange rate, there are two important considerations: first, the renminbi exchange rate against the dollar determined by the given basket of currencies; second, the magnitude of renminbi appreciation that is desirable or affordable for China. Only after weighing the two considerations, will the central parity be announced each day. Hence, the central parity is not necessary based on the parity set on the previous business day. Primary dealers in the foreign exchange market will offer bid-and-ask prices, but it is hard to say that they can determine the central parity rate, because they will try their best to toe the line. Persistent outliers will lose their position as primary dealers in the foreign exchange market.
After the outbreak of the global financial crisis in 2008, the yuan re-pegged to the dollar temporarily, and de-pegged and resumed appreciation again in June 2010 after an eighteen-month hiatus.
In April 2012, the PBOC widened the yuan’s daily trading band against the US dollar to 1 percent from 0.5 percent, as part of the effort by the central bank to allow market supply and demand to play a larger role in the determination of the renminbi exchange rate. The central bank pledged that it would maintain the “normal fluctuation” of the renminbi exchange rate, stabilize the rate at “reasonable and balanced levels,” and keep the macro economy and financial markets stable.
In the 1980s, China was still in the process of forming its growth strategy, and hesitated in choosing between import substitution and export promotion. In the 1990s, China’s exchange rate policy was increasingly aimed at promoting exports, which in turn was driven by the desire for the accumulation of foreign exchange reserves.
After the reform of the exchange rate system in 1994, China achieved a comfortable position in international balance of payments. It seems that China was happy with the managed float and had no problem with allowing market demand and supply to determine the exchange rate. In fact, after the 1994 reform, the renminbi exchange rate was on the rise, driven by the international balance-of-payments surplus. However, the Asian financial crisis changed China’s policy prospects abruptly.
During the Asian financial crisis, to adopt a de facto peg to the US dollar rather than to engage in competitive devaluation was absolutely the right decision. The question is why after the crisis, the Chinese government refused to de-peg from the US dollar. The causes behind China’s insistence on pegging are multi-fold. First, in 2003 the Chinese government was still not sure whether the economy had recovered truly. It was widely believed that even a small appreciation of the renminbi would lead to widespread bankruptcy and millions of jobs would be lost. Second, it was believed by many that because of “irrational renminbi appreciation expectations,” one small appreciation would invite more capital inflows betting on renminbi appreciation, which in turn would put more appreciation pressure on the renminbi. Hence, a de-peg would make appreciation uncontrollable and eventually cause excessive appreciation of the renminbi with dire consequences for the economy. Third, some US economists successfully persuaded many Chinese economists who have the ear of Chinese decision makers to believe that Japan’s economic bubble was caused by the yen appreciation after the Plaza accord in 1985 and that if China allowed the renminbi to de-peg and appreciate, the Chinese economy would suffer in the same way as Japan has since 1985. Fourth, the US government’s open campaign to press China to appreciate the renminbi created great public resentment. To give up the peg would be looked at as bowing to US pressure. Hence, renminbi appreciation, to a certain extent, became a political issue.
Having entered 2005, the economic situation had become more favorable for appreciation: China’s exports jumped by 20 percent on the year; the economy grew at a more than 10 percent per annum; house prices were rising rapidly, and China’s foreign exchange reserves were approaching US$700 billion. The fear of the deflationary effect of appreciation on the economy receded significantly. At the same time global imbalances were worsening rapidly and international pressure on renminbi appreciation was gathering momentum. The PBOC finally was able to adopt a more flexible exchange rate regime and allow the yuan to appreciate by 2 percent in July 2005.
Because China had been running huge twin surpluses (current account and capital account surpluses), the renminbi has been constantly under appreciation pressure. In order to guide the renminbi to appreciate in a gradual way, the PBOC intervenes in the foreign exchange market constantly. When the PBOC is considering the intensity of intervention, it will take into consideration mainly the following factors:
• macroeconomic situation, especially with regard to growth and inflation;
• long-term adjustment needs;
• trade balance; and
• sterilization ability.
According to the theory of “impossible trinity,” it is possible to have only two of the following three things: a fixed exchange rate, free flow of capital, and independence of monetary policy. As a large economy, there is no doubt that China has to maintain the independence of monetary policy. Hence, when it decided to embark on a process of gradual currency appreciation, China had to treat capital account liberalization in a cautious way. Otherwise, cross-border capital flows would destabilize the economy. In fact, the much talked-about excess liquidity since 2006 is partially attributable to the slow appreciation in the face of large twin surpluses.
One of the most important reasons for China to adopt the exchange rate regime of referring to a basket is that a basket peg can create the possibility of two-way movement for the renminbi exchange rate, regardless of what happens to China’s international balance-of-payments position. The two-way movement of the exchange rate in turn will create uncertainty for international speculators so as to deter speculative capital inflows. Unfortunately, until the global financial crisis broke out in 2008, the US dollar had been depreciating continuously against all other major currencies. Hence, the renminbi had been appreciating almost uninterruptedly. When the new exchange rate regime fails to deter capital inflows betting on renminbi appreciation, capital control has to play an important role in blocking the inflow of hot money as well as reducing the appreciation pressure on the renminbi.
By and large, China’s exchange rate policy has succeeded in allowing the renminbi to appreciate so as to reduce China’s external imbalances, while maintaining economic and financial stability. In fact, since 2005 the renminbi has appreciated by more than 30 percent in real terms.
However, the downside of the gradualist approach to renminbi appreciation is also obvious. Gradual appreciation means that the PBOC has to intervene in the foreign exchange market constantly. As a result, China piled up huge foreign exchange reserves. In 2003 when the discussion on the pros and cons of renminbi appreciation was just starting, the amount of China’s foreign exchange reserves was some US$400 billion; now it is approaching US$4 trillion, well beyond any reasonable need for China. The bulk of China’s foreign exchange reserves are invested in US government securities and other sovereign government bonds. While China is a net creditor to the rest of the world with some US$2 trillion net international investment position, because of its low investment returns vis-à-vis high returns of foreign investment in China, its investment income in 2011 was US$270 billion. This is a reflection of serious misallocation of resources. The situation will become even worse, if the US dollar devalues further in the future. Because China’s foreign assets are denominated mostly in the US dollar while its foreign liabilities are denominated mostly in the renminbi, any devaluation of the dollar against the yuan will cause capital losses to China.
Since April 2009, the PBOC started to promote renminbi trade settlement, which is widely regarded as the beginning of renminbi internationalization. The process of renminbi internationalization essentially is a process of capital account liberalization. Thanks to the internationalization, China has de facto opened up short-term cross-border capital movements. Because the liberalization was launched before interest rate and exchange rate liberalization, opportunities for interest rate and foreign exchange rate arbitrage in China’s financial markets are abundant. In the future, global capital flows via short-term cross-border capital movements will play an increasingly important role in the determination of the renminbi exchange rate. The PBOC will be left with no choice but to speed up reform of China’s financial markets and the liberalization of exchange rate and interest rates. Otherwise, China’s ability in macroeconomic management will be seriously weakened.
Based on the review of the experience of the past twenty years, some basic patterns of China’s macroeconomic fluctuations and management can be identified.
First, China’s growth in the past two decades is mainly driven by investment. The increase in the growth rate of investment normally will persist until serious overheating occurs. The overheating develops in two stages: GDP grows at a rate higher than potential growth rate first and then inflation worsens.
Second, the correlation between growth and inflation was high, but with unpredictable time lags. Whenever the growth rate of GDP surpasses the potential growth rate, inflation would rise at an accelerating pace several quarters later. Whenever GDP growth slows, inflation will fall with similar time lags. Hence, before prices spin out of control, some preemptive action has to be taken. Similarly, when growth is slowing down, inflation may still be high and even rise further. If the government fails to change policy direction in time, deflation may set in several quarters later.
Third, money does matter in China. Changes in money supply will eventually lead to changes in real GDP and inflation, though with various lags that are difficult to predict.
Fourth, in normal times, to manage the macro economy via changing money supply is superior to credit control. However, because the availability of credit is the most important prerequisite to investment growth and hence GDP growth, in some extreme circumstances, despite side effects, targeting credit and using “moral persuasion” to achieve the credit target is more effective than control through money supply.
Fifth, following the progress in financial liberalization and innovation, it is becoming increasingly difficult for the PBOC to control the broad money M2 with precision and through controlling M2 to influence real output and inflation. Hence, the PBOC needs to shift from targeting monetary aggregates to targeting a market-determined benchmark interest rate in a timely fashion.
Sixth, fiscal policy is very effective in boosting economic growth and overcoming deflation. However, the Chinese government was very cautious in using fiscal policy to stimulate the economy. As a result, it was able to maintain a strong fiscal position, which in turn provided the government with ample room to boost the economy in the face of adversity.
While GDP growth and inflation fluctuate around a long-term growth trend in a cyclical pattern, some fundamental changes have occurred over the past twenty years. First, the share of fixed asset investment in GDP has reached 50 percent. It has become more and more difficult to promote GDP growth by stimulating investment. The same is true of exports. Second, thanks to the frequent use of expansionary monetary policy, the growth rate of broad money has been significantly higher than that of nominal GDP growth for the best part of the past two decades. As a result, China’s M2-to-GDP ratio has reached 180 percent, the highest among major economies in the world. This extremely high degree of monetization of the economy implies that it will become increasingly difficult for the PBOC to control the liquidity of the economy via changes in money supply. This is attributable to the fact that the largest component of M2 – household saving deposits – is endogenous. Furthermore, its inflationary implications are also worrying. Third, the strongest point of the Chinese economy in terms of macroeconomic management was – still is – its low public debt-to-GDP ratio. However, complacency is dangerous. China’s contingent liabilities in the forms of local government debts and state-owned enterprise debts are high. In the near future, China’s fiscal position can worsen quickly, because the room for improving tax collection has been narrowing, potential economic growth is slowing, which of course is a controversial issue at the moment, and public expenditures are likely to rise rapidly.
All in all, one of the most important problems with China’s macroeconomic management is that the short-run macroeconomic stability on many occasions is achieved at the expense of the structural adjustment and the rational allocation of resources. China has run down its ammunition gradually. To achieve decent growth and economic stability for the next decade, how to strike a balance between short-run macroeconomic stability and long-run structural adjustment is a big challenge facing China. The recent changes in the supply side of the economy, such as the decrease in the working-age population, have made the challenge even more acute.
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2 Rongji Zhu, “Speech at Central Economic Work Conference” (1994).
3 A puzzling phenomenon in 1995 is that while the growth rate of money supply fell rapidly, the growth rate of credits rose precipitately, peaking at 44 percent in June 1996.
4 Genyou (2001).
5 Green (2005).
6 A minor contributing factor to the increase in tax revenues was a result of the expiry of some tax concessions.
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