Redesigning the Dragon Financial Reform in the Peoples Republic of China

Redesigning the Dragon

Financial Reform in the Peoples Republic of China

Duncan Marsh

Anna Pawul

Dmitri Maslitchenko

V550, Government Finance in the Transitional Economies

21 November, 1996

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

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

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

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

Table 1.

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

Table 2.

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

Chinese economic reform has one other characteristic that sets it apart from that of the former Soviet Union, the absence of democratic reforms. The current transition is being carried out within the “socialist framework” and for the most part is centrally controlled. Much of the world waited to see whether the economic transition would derail after the Tiananmen incident in 1989; it did not. However China did seem to be looking for a way of separating itself from reforms and democratic upheaval that were happening in the former Soviet Union(6). In 1992, Deng Xiao Ping toured the southern economic zones - a journey significant for its highly symbolic approval of the reform and investment efforts he witnessed - and coined the phrase “socialist market economy”. Deng emphasized that this transition must promote the development of productivity, strengthen the national power and improve people’s standard of living, stating that, “..with all these achievements secure, our socialist foundation is greatly strengthened..”(7).

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

Revenue, Expenditure and the Budget

One problem of major proportion facing the Chinese government is that central government revenues are growing at a much slower rate than the overall economy, and a growing budget deficit has resulted (see Table 3 in Appendix, page 20).(8) This is especially debilitating in the face of increasing demands from the surging economy for investment in infrastructure and with the need for investment in a reformed social insurance system that will come with economic disruptions caused by continuing liberalization. Expenditures have also been falling as a percentage of GDP, but are growing faster than revenue.

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


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

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


· Subsidies to the loss-making SOEs, in the form of loans or direct subsidies (see Table 4). China’s 1995 budget deficit was around a mere 1.5% of GDP. If policy lending by centrally controlled banks - most of which is, effectively, transfers to SOEs which can never afford to pay back these loans - is taken into account, the central government’s true deficit is 6% of GDP or higher.(10)

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

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

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

· Inflation-indexed interest subsidies on bank deposits and treasury bonds, which have been kept high by high inflation rates.

Table 4.

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

For a country controlled by a Communist party, the government’s proportion of economic activity has been remarkably small, even before implementation of reform. In 1995, official government spending was just 11.6% of GDP. Off-the-books revenue raising schemes by local governments may mean the state’s total revenue is two times the official level.

The extra-budgetary revenue investment was dispersed, uncoordinated and did not fulfill the central government’s investment priorities. The central government faced growing infrastructure demands, but with shrinking (in proportionate terms) assets available, has been forced to reduce capital construction spending substantially. Also, expenditures on administration, culture, education, and welfare increased over the reform period, and reduced the government’s ability to spend on infrastructure.(12) (See Table 5 in Appendix, page 22.) The increases in administration spending are particularly troubling, because of government policies to reduce control of the economy and shrink some government bureaus.

One of the stated goals of the Ninth Five-Year Plan is to eliminate the budget deficit by year 2000. But this goal is highly unlikely to be achieved due to other conflicting goals, like spurring employment, which may mean increasing subsidies to unprofitable SOEs; reducing regional income disparities; and strengthening agriculture, which is seen as a key to controlling inflation.

Christine Wong, an expert on the Chinese financial system, identifies three necessary changes to restore the health of the budget: First, the tax administration must be strengthened. Second, the tax structure must be reformed so that it is neutral across products and sectors. Third, the revenue-sharing system between local, provincial and national levels of government must be revamped, with clearer tax assignments in line with each levels set of responsibilities. The central government’s control over the tax system and share of total revenues will likely have to be increased. The next two sections will address these proposed changes.(13)


The Pre-Reform Tax System

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

1994 Reforms

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

Enterprise Income Tax. This unified corporation tax taxes companies at a single 33% rate. Foreign enterprises and joint ventures are still enjoying lighter tax burdens, because of the fierce competition between regions to attract foreign investment, but these privileges are to be gradually eliminated.

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

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

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

Business tax for services. Service industries will face a business tax of 3% to 20% on sales in place of the VAT. This tax also will apply to transfer of intangible assets and the sale of real estate.(15)

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

1996 Reforms

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

Revision of Tax Collection Structure

In order to make the above tax policy changes effective, the tax collection system must be revamped and greatly improved. The current structure is based on a system of revenue contracts between enterprise and government unit, and between local and central governments. One of the necessary reforms involves tax exemptions, which local governments often have the authority to grant to enterprises who for one reason or another are unable to pay their taxes. This is a fundamental weakness in the Chinese fiscal system: local government has decision-making authority to grant exemptions on a tax the proceeds of which may in large part be assigned to governments above. Numerous conflicts of interest can appear to reduce incentives to enforce the tax at the local level.(17)

To address these changes, China in 1994 initiated the setting up of a centrally-managed National Tax Service. This would replace the contract system with a national “tax system,” based on uniform rules of tax assignment and tax sharing. Certain assignments will be assigned to local governments, and others to central government; others will be shared according to predetermined formulas. Interestingly, in 1995, a special police unit was set up to protect tax collectors under this new program.(18)

A potential obstacle to tax reform comes from local governments. Local governments have traditionally supported reforms. But this is because the reforms have usually given them greater autonomy. The tax system reforms need to restore some control over investment and spending back to the central government, which could encounter local opposition. Allowing local governments some discretion over local tax rates can give them some of the autonomy they desire, and provide greater incentive for intergovernmental cooperation.

Few reports exist at present on the implementation of these reforms. Certainly, the spirit and scope of the reforms has been well-received by analysts, though more changes are advocated. But it will take several more years to determine the success of the reform of tax collection structures at the local level.

Intergovernmental Fiscal Relationships

A product of economic reforms in transitional economies is often a shift in intergovernmental fiscal relationships. In the transition from centralized economy to market economy it is often from a relationship where the local or provincial government is the receiver of the “plan” to the local or provincial government proceeds with a greater autonomy. The evolution of this relationship in the PRC has been very similar. However, the provincial or local governments were at an advantage over many other transitional economies because the Chinese system had the following characteristics 1)local implementation capacity was already established in the rural areas 2)China in most areas has a high ethnic homogeneity and 3) there was much to gain by inter-province trading(19)

The very nature of Chinese economic reforms, gradual and incremental, allowed “scaffolding” of behavior. Partial reforms provided the environment to learn behaviors that could then be applied to the next level of reform. Chinese economic reform was also structured on the idea of decentralization. The establishment of Special Economic Zones (SEZs) encouraged the local areas to develop their own strategies to attract business and allowed them the freedom to implement the strategies. The very earliest reforms, breaking up of farm communes, were also carried out at the local level.

Many of the SEZs are doing very well and people living in these areas are enjoying a higher standard of living than they had previously enjoyed. However, tax collection still remains a difficult endeavor with compliance at only 70%. In order to improve the poorest areas in China, policies and programs that are able to move this revenue to the poorer areas will be needed. This can take the form of a better accounting system to ensure that all taxes due the central government for infrastructure development actually arrive there.

Banking Reforms, State Owned Enterprises and the Social Safety Net

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

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


The Central Bank was established in 1984. In 1987 two additional universal banks were formed and non-bank financial institutions were started. In 1988 new capital markets were formed and the secondary trade of government bonds was allowed. In 1990 the Shanghai and Shenzhen stock exchanges were opened. In 1992 all treasury bonds were issued through underwriters(23). At the end of 1994, the PRC had a total of 13 banks (of which 3 were specialized banks and 3 were comprehensive banks). The new “financial system” contained 20 insurance companies, 391 trust and investment companies and greater than 60,000 credit cooperatives that operate in local areas(24).

During the summer of 1995 the central government announced a series of new banking laws would be established. These laws were the People’s Bank of China Law, the Commercial Banking Law, the Negotiable Instruments Law and the Guarantee Law. Up until this time the roles of each party in the framework of financial transaction hadn’t been clearly defined. These laws begin to lay the comprehensive groundwork for financial transactions(25). The People’s Bank of China Law which was established in the summer of 1995 addresses the internal organization of the People’s Bank of China, its monetary policy, its supervision and tries to establish its autonomy from provincial and local governments (it is still under the control of the State Council). This law has provisions in it for setting the prime lending rate, rediscount window, amount of funds to be lent to commercial banks, and the trade of treasury bonds, government securities and foreign exchange. It also bars the People’s Bank of China from financing the budget deficits of the central government and local governments. The Commercial Banking Law addresses the mission of commercial banks. These are still under the guidance of the State Council and still must issue policy loans (although the law also states that any losses due to defaults on these loans will be compensated by the State Council).

The Negotiable Instruments Law is similar to the United States’ Uniform Commercial Code. The Guarantee Law deals with mortgages, pledges, and liens. Both of these laws are hoped to standardize and regulate credit transactions in the PRC(26).

Monetary Policy

Monetary policy in the PRC is currently administered through a central “credit plan”. This plan, which is administered by the State Council, sets credit quotas for each bank and also facilitates direct bank financing of enterprises. In the current system the major objectives of the specialized banks is to provide loans for various projects, agriculture and foreign trade. The main recipients of these loans are the state owned enterprises (SOEs). The terms and rates of these loans are very favorable (usually 12%(27)). Therefore the demand for these loans is higher than the supply and private companies have to rely on other sources. This can take on various means and can often lead to underground lending operations.

The convertibility of RMB has also been undergoing changes. Prior to January 1, 1994, there were two money systems in China. One for local use, the other for foreigners. These Foreign Exchange Certificates (FEC’s) were redeemable only in state operated stores and restaurants. Only higher level officials were able to use these and most imported goods required the use of FEC’s. Since doing away with FEC’s , RMB convertibility was relegated to official “swap shops”(28). Now, with the correct permit businesses can use any large bank to exchange money. However, the government has also begun to establish hard currency audits as well as trying to force businesses to use the same bank for all of their transactions (a way of tracking how much money is being exchanged). The new convertibility does meet IMF requirements(29).

State Owned Enterprises and the Social Safety Net

As illustrated above, the banking system and state owned enterprises are closely linked (see Table 7 in Appendix, page 24, for financing of SOEs). According to Chinese government statistics, up to 20% of the debt of state banks is bad debt. International estimates place this figure at almost double that amount(30). Recently in Jiangsu province, 30 SOEs declared bankruptcy telling the banks they were not going to pay their debts. If all the banks in China did this it would lead to bankruptcy of the banks(31). SOEs account for only 34% of industrial output but consume 73.5% of government investment(32). Most have an average debt equal to 75% of total assets(33). According to an Oxford Analytica study, in the first eight months of 1995, SOE industrial output expanded by only 8.3% compared with a 13.7% increase for all industry. And according to estimates, non-SOEs, on average, required less than a third as much investment to achieve equivalent industrial output.(34)

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

However, the central and local governments are still hesitant to shut down even the most inefficient SOE. Currently, 7 out of 10 industrial workers work in a SOE. The SOE provides not only a job but housing, education, pensions, insurance and often energy sources and commodity shops on site. The World Bank estimates that only 56% of total expenditure by SOEs is actually on wages, the rest is on “social spending”(37). Therefore, any reform involving the SOEs must also involve reform and development of a social safety net. Pilot programs have been started where local governments create pension pools and are putting aside payroll taxes for education, health and unemployment benefits. It is also important to note that the question of “social security” reform is being worsened by additional factors. Population in the PRC is progressively growing older. This phenomenon can be attributed to increase in life expectancy due to better living conditions and the one child per family policy.

How Should Reforms be Implemented?

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

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

This over time would lesson the State Councils role in directing the day to day functions of the banks and eventually do away with the credit plan. Banks would be able to allocate resources appropriately and to set their own interest rates.

2) Improve the Central Bank’s management of monetary aggregates.

This over time would improve the consistency of banking laws by ensuring that they are used and would also remove policy lending from the banks and put it into the budget where it should be. This would also allow for the development of the Central Bank as an institution.

3) Transform state commercial banks into real commercial banks.

This step would help to free the banks from the current crises of bad debt and allow them to loan money to the newly emerging private sector.

4) Improve governance, diversify ownership and lower subsidies for SOEs.

In the short term this would include implementing an accounting system and independent audits, give autonomy to the managers, getting rid of unviable businesses and restructuring those SOEs that can be.

5) Transfer social services to the government.

This would reduce the burden on newly restructured enterprises. Over time this would allow for a national system to be implemented.


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

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

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

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

· Clarifying property rights and privatizing them where necessary. Requires re-creating the institutions that support market exchange and shape ownership, and especially the rule of law.

· Reshaping social services and the social safety net to ease the pain of transition while propelling the reform process forward.

Examination of the Chinese experience shows that liberalization has taken place to some degree, though much reform of prices, trade and markets is still to be done. However, privatization and the assignment of property rights are still very undeveloped, and the most difficult parts of transition ahead are dependent on a still-unachieved transfer of the social safety net from enterprise-based to government control.(40)

Were China to continue to grow at the rates of the last two decades, it would surpass the United States as the world’s largest economy in less than twenty years. Though some tapering off in the growth rate is expected, China, with its sheer size and dynamism, is emerging as one of the world’s economic powers. The reform policy choices it makes during this period of transition thus have not only domestic but international significance, as China’s domestic economic and social stability will be felt internationally. The rest of the world has ample reason for assisting China in seeing these reforms through peacefully. Opening of economic activity within China and with the rest of the world will assist the process of political liberalization within the country, and will provide enhanced regional and global security.

Table 3. The Fiscal Situation in the Reform Period

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

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