CHINA: TURNING TO FISCAL AND MONETARY POLICY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85T00310R000200010004-0
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 18
• Document Creation Date: December 21, 2016
• Document Release Date: March 20, 2009
• Sequence Number: 4
• Publication Date: July 1, 1984
• Content Type: REPORT

Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
Directorate of Secret
Intelligence
China: Turning to
Fiscal and Monetary
Policy
Secret
EA 84-10138
July 1984
Copy 3 4 9
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
f~ fiyC, Directorate of Secret
Intelligence
China: Turning to
Fiscal and Monetary
Policy
This paper was prepared by
Office of East Asian Analysis. Comments and queries
are welcome and may be directed to the Chief
China Division, OEA,
Secret
EA 84-10138
July 1984
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
Secret
China: Turning to
Fiscal and Monetary
Policy
Key Judgments One of the most troublesome side effects of China's five-year experiment
Information available with economic reform has been Beijing's perception that it has lost control
as of 26 May 1984 over macroeconomic activity. The problem was a major factor behind the
was used in this report.
extended debate within the party in 1981 and 1982 over the need for
reform versus the need for tighter central planning. Proponents of reform
prevailed, in part by advocating the use of fiscal and monetary tools to con-
trol aggregate demand.
Beijing has been forced to make major institutional changes to facilitate
the use of fiscal and monetary policy. The moves have enabled the
government to restore a measure of control over the economy and, hence,
are partially responsible for Beijing's recent decision to push ahead with
new economic reforms. In the wake of new efforts to decentralize
decisionmaking authority, we expect several fiscal and monetary tools to
become even more important over the next few years:
? Bonds and foreign borrowing to finance budget deficits.
? Major experimentation with new taxes and changing tax rates.
? Establishment of a competitive banking system and increased reliance on
bank loans instead of budgetary allotments.
? Active control of the money supply, probably by the newly established
Central Bank Council.
Several of China's top leaders-including Politburo members Zhao
Ziyang, Hu Yaobang, and Wan Li-have staked their careers on resolving
China's economic problems. Although the reforms they promoted helped
improve overall economic performance somewhat, serious problems re-
main. Much of the waste and inefficiency still present in the industrial
sector stems from China's irrational price system, and demand-
management tools are particularly unsuited for dealing with price prob-
lems. Because conservative critics are quick to attack shortcomings, the
leadership is under pressure either to achieve improved results or abandon
the controversial reforms. If Beijing continues to eschew major price
reform, we believe it could become disenchanted with the results of
industrial reform and may be forced-perhaps as early as 1986-to resume
tighter central control.
iii Secret
EA 84-10138
July 1984
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
China: Turning to
Fiscal and Monetary
Policy F---]
Since the watershed Third Plenum of the 11th Cen-
tral Committee in 1978, China has been involved in
an unprecedented experiment with economic reform.
In an effort to eliminate the tremendous waste and
inefficiency that characterized the economy since the
1950s, Beijing began to push decisionmaking author-
ity-once reserved for central planners-to local en-
terprises. It also promoted competition and loosened
control to stimulate profit-oriented performance. The
experiments, though limited, represent a major turn-
around for what had been one of the world's most
tightly controlled, egalitarian economies
would enable them to assert direct control over aggre-
gate demand' and avoid a recurrence of the economic
disasters that had plagued the Kuomintang regime.
Under that regime, sharp increases in consumer and
investor spending-fueled by the printing of money to
cover government spending-sparked a period of hy-
perinflation. To avoid this and all other cyclical
fluctuations in economic activity, a tightly controlled
system was designed:
? Private enterprises were controlled, then turned into
state-owned units.
Although the devolution of decisionmaking authority
spurred productivity-at least in agriculture-it also
left Beijing with sharply diminished control over
macroeconomic behavior. Consumer and investor de-
mand spurted, straining raw material and energy
supplies and putting strong upward pressure on prices.
Fierce competition in the foreign trade sector also
created damaging price pressures. Faced with drop-
ping the reforms or finding other control mechanisms,
Beijing began adopting variations of fiscal and mone-
tary policies used in the West.
This paper briefly describes the tightly controlled,
centrally planned economy that Deng Xiaoping and
his fellow pragmatists inherited, shows the degree of
control that was lost when reforms were introduced,
and highlights the fiscal and monetary measures
taken to reassert control. The paper also assesses the
preliminary results of monetary and fiscal policies, as
well as some remaining problems that are not resolv-
able using monetary and fiscal policy.
Direct Control-The Legacy of Mao
The Chinese Communists spent much of their first
few years in power systematically dismantling the
existing market-oriented system and replacing it with
a planned economy modeled after that of the Soviet
Union. Chinese economists hoped that central plan-
ning, aside from meeting their ideological needs,
? Land was redistributed, then collectivized in 1955-
56, then communes formed in 1958.
? Prices were rigidly fixed (producer goods artificially
high, consumer goods low) to promote industrial
production and to prevent inflation.
? The currency (renminbi) was made inconvertible,
and the Ministry of Foreign Trade monopolized all
imports and exports to insulate China from fluctua-
tions in aggregate demand caused by international
trade.
? Investment was incorporated into the planning proc-
ess, with the state determining both the quantity
and direction of most investment.
' Aggregate demand refers to the total demand for goods and
services produced in a given economy. In simple mathematical
terms, the equation most often used to express aggregate demand is:
Y = C + I + G + (X - M). That is, aggregate demand for a coun-
try's total output (Y) can be broken into four component parts:
consumption (C), investment (I), government expenditure (G), and
net foreign trade-exports (X) minus imports (M). For a market
economy, C, I, X, and M are commonly regarded as subject to the
whims of private behavior; only G is under direct government
control. For a planned economy, the state monopolizes virtually all
industrial, commercial, and financial activity. Only C is considered
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
? The use of cash was restricted. Enterprises were
forced to conduct most of their business through
account transfers at state banks.
? Private consumption was regulated by wage and
price controls, commodity-rationing schemes and
forced savings, and denial of consumer credit. Infla-
tionary pressures showed up not as higher official
prices, but as longer queues.
Inefficiency-The Iron Rice Bowl
Although the economy recovered sharply and per-
formed well during the early stages of Communist
rule, major problems began to surface in the late
1950s and worsened throughout the following two
decades. When Beijing abandoned market pricing and
assumed the job of allocating resources, it introduced
tremendous inefficiencies. Resources began to move
where they were directed, not where they were need-
ed. Political clout-not efficiency-determined the
direction of flow. The government's emphasis on
increasing output at all costs led firms to produce
large quantities of unwanted, unusable goods. Maoist
egalitarian principles prevented factory managers
from rewarding quality work or firing unproductive
labor. Because factories were required to pay the
salaries of employees they laid off, few workers were
let go under any circumstance. This "iron rice
bowl"-guaranteed income and employment regard-
less of performance-has been the factor most often
cited to explain the waste and inefficiency that has
become inherent in the Chinese system. The leftist
leadership under Mao viewed these economic prob-
lems as necessary, acceptable costs of ideological
purity.
Economic Reforms: Efficiency at a Price
As Deng Xiaoping and his pragmatic followers con-
solidated their power, it became increasingly clear
that one of their top priorities would be to attack this
inefficiency. Since 1978 they have introduced a series
of "economic reforms," the basic thrust of which has
been to decentralize decisionmaking authority, giving
local government and enterprise managers greater
autonomy, but also making them responsible for
profits and losses. Rather than a comprehensive pro-
gram carried out in stages, the reforms came as a
series of groping experiments. Various proposals have
been implemented, sometimes nationwide, sometimes
The Bonus System: Trial-and-Error Reform
The implementation of the bonus system serves as a
useful example of Beijing's groping approach to
economic reform. In 1979, in an effort to spur
productivity, Beijing gave enterprise managers au-
thority to distribute bonuses to their workforce.
Instead of using the bonus system to reward meritori-
ous performance and enhance incentives, however,
managers-many of whom achieved their positions
during the Cultural Revolution as a result of their
political orthodoxy-distributed bonuses in egalitar-
ian fashion, across the board. Xinhua complained
that in 1981, even after some factories were closed
down, their unemployed workers continued to draw
their full wages and bonuses. The result of this
misuse of bonuses was constant or even declining
productivity and sharp upward pressure on prices.
Beijing responded in 1982 by curbing the amount of
retained earnings available for bonuses and by issu-
ing orders that payments were not to exceed produc-
tivity gains. This year, however, provincial authori-
ties successfully pressured Beijing into allowing
enterprises more autonomy. Rather than setting up-
per limits on bonuses, Beijing now applies a progres-
sive tax on these payments. There is no penalty for a
yearend bonus amounting to less than two and a half
months' wages. Enterprises awarding bonuses larger
than the equivalent of six months' wages, however,
will be required to pay four times that amount in
taxes
only regionally. Where a specific reform was deemed
effective, it was widely promoted. Where Beijing
believed a reform created more problems, it was
curbed.
Although the reform program remains controversial,
almost all sectors of the economy have been affected:
? Agriculture. Over three-fourths of the land is now
under effective control-though not legal owner-
ship-of peasant households.'
25X1
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
? Industry. Enterprises that formerly remitted all but
a small share of their profits now retain a much
larger share, which, with limitations, they may use
to pay bonuses, fund welfare programs, or invest in
new facilities.
? Finance. Provincial governments now have greater
discretion in spending locally generated revenues.
? Commerce. Free markets have reappeared with
official blessing, and enterprises are permitted to
sell some of their products outside the government-
run commercial system.
? Banking. Loans are gradually replacing government
grants as sources of fixed and working capital.
? Foreign Trade. Beijing has allowed some provincial-
and municipal-level organizations to conduct their
own trade and has established four special economic
zones with freedom to trade and accept foreign
investment.'
? Private enterprise. Individuals may now establish
small businesses employing up to five "helpers or
apprentices."
Losing Control-Reform's Weak Link
By reintroducing competition and profit-maximizing
behavior-crushing the iron rice bowl-Beijing hoped
to capture the efficiency of the marketplace while
retaining the benefits of planning. In the agricultural
sector, at least, the results have been satisfactory (see
table 1). For example, the combined effect of higher
farm prices, increased individual incentives, and good
weather boosted the value of agricultural output at an
average annual rate of nearly 8 percent during 1979-
83. With each step forward in reform, however,
Beijing gave up another element of control over
investment and foreign trade decisions and thus
opened the door to potentially damaging fluctuations
in aggregate demand. The problem was exacerbated
by the indiscriminate payment of bonuses and in-
creased procurement prices for agricultural products,
both of which pumped cash into the household sector.
The increased household income gave Beijing further
cause for concern about rising consumer demand.
' Although Beijing has made several attempts over the past two
years to recentralize trade, it still exerts much less control than it
Prereform Reform Era
(1974-78) (1979-83)
a Prereform data are averages for 1965-78, reform-era data are for
1978-82.
Evidence of Beijing's gradual diminution of control
was most clearly reflected in investment trends (see
figure 1). In 1978, nearly 85 percent of total invest-
ment in capital construction was funded through the
state budget, but that share fell to less than 50 percent
in 1982. The bulk of extrabudgetary investment came
from local governments and enterprises using retained
earnings or funds borrowed from banks. The initial
1982 plan called for a 10-percent reduction in total
capital construction investment; yearend results
showed instead a 25-percent increase to 55.6 billion
yuan. More than 28 billion yuan came through extra-
budgetary avenues, a 45-percent increase over 1981.
The projects that local enterprises financed out of
extrabudgetary investment siphoned off construction
materials such as cement, steel, and glass that the
government needed to carry out work on priority
infrastructure projects. And once completed, many of
these locally financed projects began competing for
raw materials needed by larger, more efficient state-
run enterprises.
Burgeoning budget deficits were further evidence of
Beijing's problems with control. After registering
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
Figure 1
China: Selected Indicators of Weakening Government Control,
1978-83
Share of Construction Funds Supplied Through
the Budget
small surpluses in 1977 and 1978, expenditures ex-
ceeded revenues by a record 21 billion yuan in 1979.'
Although Beijing was able to reduce the size of
succeeding deficits, the budget remained in the red a
total of 28 billion yuan between 1979 and 1982.
Subsidies jumped an estimated 390 percent between
1978 and 1982 as Beijing boosted agricultural pro-
curement prices (in an effort to improve rural living
standards) while holding the line on retail food prices
(to avoid cutting into urban consumption). By 1982,
government subsidies outweighed capital construction
as a share of the total budget.
`The figures given in this paper have been modified by the IMF to
meet standard Western accounting practices and hence differ from
official Chinese statistics. Beijing includes domestic and foreign
borrowing as revenue items, while Western practice is to exclude
them from budgetary calculations and consider them, instead, as
means of financing a given deficit. On the expenditure side, Chinese
Revenue shortfalls increased the deficit. Enterprises,
exercising their decisionmaking authority, found ways
to avoid remitting profits to the government by over-
stating costs, giving across-the-board wage bonuses,
and understating actual revenues. The drop in net
profit remittances from state enterprises was unex-
pectedly sharp, from over 51 percent of total revenue
in 1978, to only 29 percent in 1982.
In the foreign trade sector, Beijing saw its control
wane because of reform. Provincial and municipal
authorities engaged in open bidding wars for foreign
business. Hard currency losses from the price compe-
tition were large, perhaps as much as $1 billion in
1981 alone. The Ministry of Foreign Trade watched
from the sideline as its newly adopted policy of
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
-11
avoiding duplicate purchases of expensive Western
equipment-by acquiring the technology and repro-
ducing it domestically-was ignored by enthusiastic
local traders. Instead, under the reforms, several
enterprises willingly laid out the foreign exchange
necessary to acquire the equipment directly from the
West. Hence, Beijing began to see inventories build in
distinctive cyclical pattern of rapid advance and
measured retrenchment.'
its own machine tool industry.
The unanticipated surge in aggregate demand put
strong upward pressure on prices. Official prices in
China are generally allowed to rise only 2 to 3 percent
per year to bolster Beijing's claim of no inflation, but
evidence suggests that, in fact, rates were much
higher after reform. For example, late last year
ing black market" was evidence of China's suppressed
inflation. Moreover, Guangdong Province published
figures that, though undoubtedly understating the
level of inflation, probably give an accurate indication
of the trends. The provincial paper reported that
commodity prices rose at annual rates of 3, 8.5, and
2.3 percent in 1980, 1981, and 1982, respectively. The
pressure prompted Beijing to issue "Provisional Regu-
lations Governing Price Control" in August 1982. The
regulations restated which product prices were still
subject to strict state control and set the limits on
fluctuations for most other prices. In May 1983 a
circular reemphasized the main theme of price con-
trol, while in mid-1983 new sanctions were issued
against unauthorized price increases.
Although some reform economists had foreseen the
development of such problems and had advocated
simultaneous adoption of new tools to control aggre-
gate demand, the regime was hesitant, largely for
political reasons. On the one hand, the reforms had
not proved their economic value decisively, and plan-
ners were concerned about introducing too much
change too fast. On the other hand, a fierce debate
was raging within the party during 1981-82 over the
need for reform versus the need for tighter control
over economic behavior. Party conservatives, led by
Chen Yun, favored a more comprehensive planning
process and somewhat less reliance on the market as
means to reassert economic control. The pragmatists,
on the other hand, advocated an expansion of the
reforms. At times, this debate brought reform nearly
to a standstill and gave Chinese economic policy a
Gradually, the reformers were able to convince the
rest of the leadership that fiscal and monetary policies
as practiced in the West offered improved control over
macroeconomic behavior without cutting gains in
productivity.
A Shortage of Demand-Management Tools
The use of demand-management tools posed two
major obstacles for the reformers. In the first place,
lack of experience meant Beijing had no idea how
sensitive aggregate demand would be to various fiscal
and monetary instruments. More importantly, most
instruments commonly used for demand-management
in market economies were not even available to
Chinese planners in the early 1980s.
The principal weapons of discretionary fiscal policy
are government expenditure and tax rates. In China,
though, government spending was viewed as only one
part of the overall economic plan. Hence, government
expenditure by itself was not viewed as a tool to
mitigate unemployment or price pressures. Nor could
Beijing rely on tax policy as even a long-term fiscal
instrument. Until 1982, state enterprises remitted
virtually all their profits to either central or local
governments.'
Beijing did have some success in the 1950s using
government bonds to ease aggregate demand pres-
sures. When China entered the Korean war in 1950, it
issued 250 million yuan in war bonds to dampen
consumer demand in the wake of sharp increases in
government spending. "Economic construction
bonds"-2.5 billion yuan worth-served the same
purpose between 1954 and 1958, offsetting a sharp
' The possibility that Politburo Standing Committee Member Chen
Yun is gravely ill may help account for the rapid advances in
reforms advocated at the May 1984 National People's Congress. E
6 A tax structure-including sales, profit, and agricultural taxes-
remained on the books; however, when Beijing began requiring that
all goods be sold at state prices to state-controlled units, the tax
25X1
25X1
25X1
25X1
25X1
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
Currency Put Into Circulation
? Wages, bonuses, and other payment to workers
? Withdrawal of savings
? State purchases of agricultural and sideline
products
? Credit to the rural sector
? State purchases of industrial and mining goods
? Miscellaneous cash business
? Overseas remittances
Currency Withdrawn From Circulation
? Money received from state and cooperative sales
? Savings deposits
? Taxes on individuals
? Service trade income
? Loan repayments
? Bond purchases
increase in official investment spending. Although
purchases were to be voluntary, in practice the party
exerted considerable pressure to market the bonds.
The fact that Chinese workers viewed bonds as just
another tax was probably the major reason Beijing
abandoned their use in 1958.
Not one of the traditional monetary tools available to
market economies-direct control of money in circu-
lation, manipulation of reserve requirements, or
changing interest rates-was available to Chinese
policymakers. The volume of currency in circulation
was a reflection of the plan. Hence, monetary policy
was passive in the sense that it was not altered to
offset fluctuations in aggregate demand. Money in
circulation depended heavily on the government's
policy toward households-the only sector relying
heavily on cash to carry out day-to-day transactions.
Increases in wages, bonuses, or purchases of products
from the household sector all increased the amount of
currency in circulation. Periodic campaigns to encour-
age savings reversed the flow.' All, however, were to a
' Fluctuations in domestic savings or remittances from abroad were
also capable of altering the amount of currency in circulation. The
former has, periodically, been a major concern for policymakers.
large degree determined at the time of the plan and
not altered to meet cyclical fluctuations.
The rapid growth of currency in circulation at the
outset of the reform movement-26 percent in 1979
and 29 percent in 1980-reflected changing govern-
ment priorities rather than an expansive monetary
policy. The decision to improve the lot of the Chinese
consumer by increasing agricultural procurement
prices and urban wages contributed to sizable budget
deficits, which in those years were financed by the
People's Bank of China. The substantial injections of
currency into the economy were not fully offset by
withdrawal of currency through sales of commodities
by state commercial departments, inflows into savings
deposits, service trade income, agricultural credit
repayments, or income from taxation.
Nor were banking authorities able to control credit
expansion. During the Cultural Revolution (1966-76),
China's banking system was reduced to little more
than a cashier/ accountant for the Ministry of Fi-
nance. Budgetary allocations were deposited in state
banks and funds drawn as required. Even when
credits demanded were above planned levels, it was
generally true that well-explained applications for
credit-short or long term-were always accepted.
The only major check on the amount an enterprise
could borrow has been the stigma of not meeting the
exact terms of the plan.
Interest rates, like most official prices in China, went
almost unchanged from 1965 to 1978. Even if they
had fluctuated with world rates, however, their im-
pact on borrowing-and hence on aggregate de-
mand-would probably have been negligible. The
restrictive power of rising interest rates stems from
the additional costs that these rates impose on borrow-
ing enterprises. In China, the influence of subsidies,
easy access to credit, and the central government's
emphasis on output almost regardless of cost all
ensure that-in a financial sense-true investment
failure is rare. Higher interest rates also do little to
encourage industrial savings. Chinese firms generally
believe it is more important to expand capacity, even
at a lower rate of return, than to earn interest on
savings deposits.
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
ae,.rvL
Wage and price controls played an important role in
regulating aggregate demand during the past two
decades. These controls were directed at the rural and
urban household sectors. One of Beijing's major con-
cerns has been that a sudden increase in consumer
spending would drive domestic prices upward. By
holding agricultural prices relatively constant from
the 1950s to the late 1970s, Beijing prevented surges
in the amount of currency circulating in rural sectors
and, hence, was able to curb excess demand. Wage
controls did the same in urban areas. The controls
were a major factor in holding the line against
inflation. When Beijing opted in 1979 and 1980 to
relax wage and price controls in an effort to improve
consumer welfare, it gave up, temporarily, one of its
most effective demand-management tools
At the outset of the reform movement, Beijing at-
tempted to control aggregate demand using the only
powerful fiscal tool in its arsenal-government spend-
. ing. Government investment in capital construction
was held flat in 1979 and then slashed 17 percent in
1980 and 28 percent the following year in an attempt
to curb mounting inflationary pressure. Defense ex-
penditures-after rising sharply in 1979 to finance
the war with Vietnam-were also cut in 1980 and
1981. Beijing attempted to use moral suasion-
threats against disobedient enterprises-to curb ex-
trabudgetary expenditure by domestic firms. Govern-
ment threats proved fairly successful in 1979, proba-
bly because local enterprises were unsure how hard
Beijing might respond to disobedience. But when it
became clear that the government was anxious to
move ahead with reform and would not clamp down,
extrabudgetary investment doubled to about 20 billion
yuan in 1980 and 1981, then hit 28 billion yuan in
1982.
Beijing also used control over the foreign trade sector
to reduce potential capital outlays and hence lessen
pressure on aggregate demand. In 1979 and again in
1981, Chinese officials refused to approve billions of
dollars worth of turnkey plant contracts that its
foreign trade corporations had signed with Western
firms. Part of the motivation for the suspensions was
to ease mounting balance-of-payments problems, but
Beijing was also attempting to reduce domestic budg-
et outlays. For each dollar spent on imported equip-
ment, Beijing claimed that it had to lay out approxi-
mately 4 yuan (the equivalent of US $2) for
infrastructure projects, wages, and other local costs.
By refusing to honor the import contracts immediate-
ly, Beijing postponed capital expenditures of more
than 10 billion yuan.
The attempt to relieve pressure by cutting back
government investment proved less than totally effec-
tive. In the first place, reductions were offset by other
government outlays. Subsidies, for example, rose 21.6
billion yuan between 1979 and 1982, more than
offsetting the 21.2-billion-yuan decline in government
spending for capital construction. Furthermore, by
withdrawing resources from much-needed infrastruc-
ture projects, government investment cutbacks may
have adversely affected China's future growth poten-
tial. The share of total expenditure allocated to key
projects dropped from 42 percent in 1978 to 30
percent in 1982.
Recognizing the deficiencies in its initial attempts at
demand-management, Beijing tried other fiscal meas-
ures. In 1981, Beijing returned to the practice of
issuing government bonds. It sold nearly 5 billion
yuan in treasury bonds to state and collectively owned
units almost entirely on an involuntary basis. As they
had in the 1950s, the bonds once again proved useful
fiscal tools for slowing aggregate demand. With the
funds siphoned from enterprises, the government cov-
ered a portion of its ongoing budget deficits without
resorting to inflationary printing of money. At the
same time, the bonds crowded out extrabudgetary
investment that almost certainly would have occurred
had the enterprises been allowed to retain their full
profits. More recently, Beijing also used the bonds to
help curb increasing consumer demand. About half of
the 4 billion yuan in bonds issued in 1982 and again in
1983 went to individuals and half to organizations.
The former, purchase of which is voluntary, carry an
8-percent annual interest rate; the latter, only 4
percent.'
BAs in the 1950s, Beijing has again taken pains to emphasize that
the bonds are to be issued on a voluntary basis. Nevertheless,
considerable pressure sometimes goes into these "voluntary" pur-
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
By far the most difficult fiscal reform attempted was
replacing the system of profit remittances with a
system of profit taxation. The new program was
designed to raise government revenue, to put more
pressure on losing enterprises by ending automatic
subsidies, and to encourage other enterprises to earn
higher profits on the understanding that these would
be shared with the tax authorities rather than confis-
cated. China introduced a nationwide, eight-tier tax
structure in June 1983. Small enterprises with annual
income of less than 300 yuan were taxed at 7 percent,
while large and medium-sized state enterprises (those
with annual incomes in excess of 80,000 yuan) fell
into the highest bracket and were taxed at 55 percent
of profit. A special "adjustment tax" was also levied
to tax away special advantages that certain enter-
prises enjoyed as a result of irrational prices, new
technology, location advantages, and so on. Any profit
the state deemed as a windfall-not directly attribut-
able to efficient operation-was subjected to the
higher tax. Beijing intends to phase out this adjust-
ment tax over time, but at present it has cut retained
earnings to the point that, according to a recent
Chinese publication, state enterprises remitted 83
percent of total profits to taxes in 1983.9
More recently, the state has decided to increase its
share of the pie by introducing other taxes. In October
1983, Beijing levied a 10-percent tax on extrabudg-
etary capital construction expenditures. The tax is
intended to discourage unwanted investment and, at
the same time, to help finance the central govern-
ment's major infrastructure projects. Other taxes
being tried experimentally include taxes on fixed
assets and circulating capital and on value added in
production. Surcharges have been levied against in-
ventories to discourage the production of unwanted
merchandise. A user tax on crude oil was introduced
in July 1982 to encourage enterprises to burn coal.F_
Revenue collection has also been strengthened. An
Office of General Financial Inspection was estab-
lished in mid-1983 to audit units nationwide and
crack down on tax fraud. By early 1984, more than
190,000 auditors had been mobilized to spot-check a
9 During 1979-82, when selected regions were experimenting with
tax reform without an adjustment factor, the Chinese reported that
some enterprises retained as much as 70 percent of profits. Beijing
was clearly unwilling to give enterprises this much latitude over
third of the nation's enterprises and establishments.
Violations amounting to 3.5 billion yuan were discov-
ered, 1.9 billion of which were owed to the state. F_
Although still in its early stages, the tax reform
program is already creating problems. In an effort to
increase its revenues, the steepest adjustment tax has
been applied to the most profitable enterprises-a
practice Beijing refers to as "whipping the fast ox."
As a result, some firms now retain less than 5 percent
of total profits, making it difficult for them to award
bonuses or to acquire needed technology. The firms
probably benefiting most from the new system are the
few that remain outside it. The Ministry of Metallur-
gy, which has been allowed to set its own guidelines,
adopted a "profit responsibility system," where each
factory remits a fixed quota to the state and retains
the remainder as its profits. Some firms reportedly
retain as much as 80 percent of profits under this
system.
Making Monetary Policy an Option
Banking
Perhaps the most convincing evidence of China's
willingness to experiment with market-oriented
demand-management tools has been its reform of the
banking system. Although use of fiscal tools required
innovative policy moves, monetary reform involved
major institutional rebuilding. Over the past four
years, Beijing has been setting up a network of
commercial and industrial banks to relieve the Peo-
ple's Bank of China (PBOC) of the burden of exercis-
ing financial supervision over all public enterprises:
? On 1 January 1984, all commercial banking respon-
sibilities were taken from the PBOC, which is now
to function solely as a central bank, formulating and
carrying out overall monetary policy.
? Commercial banking functions previously carried
out by the PBOC have been delegated to the newly
formed Industrial and Commercial Bank.
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
Secret
? The Agricultural Bank-formally reestablished in
February 1979 after a 10-year hiatus-now serves
as the main channel for both state investment and
credits to agriculture as well as for collection of
revenue in the countryside.
? The Construction Bank has been placed under joint
supervision of the Ministry of Finance and PBOC,
and is charged with supervising construction
investment.
? A Central Bank Council-made up of executives
from all the banks-has recently been formed to
discuss important national financial policy questions
(see figure 2).
The long-term goal of banking reform is to set up
institutions that eventually will be capable of pursuing
an active monetary policy. Monetary authorities un-
der such a system could cut back lending when
aggregate demand is considered too strong and could
make additional loans when demand is weak. The
monetary authority itself would determine the course
that aggregate demand would take. At present, banks
are forced to lend to almost every enterprise that
demonstrates a need for funds to meet planned pro-
duction. In the future, Beijing wants the banking
system to assist in the drive for efficiency by making
loans on the basis of profitability.
Interest rates
Beijing has also attempted to make greater use of
interest rates to influence microeconomic decision-
making. To encourage savings and reduce the amount
of cash in the hands of consumers, interest rates paid
on deposits have been raised three times since 1978.
New types of deposits have been created, broadening
the range of financial assets available. In 1982,
enterprises and organizations were for the first time
permitted to hold time deposits, which earn higher
interest. Perhaps the most important adjustment,
however, was the general increase in interest rates on
loans, implemented in January 1982. The standard
rate on circulating capital loans was raised from 5.04
percent a year to 7.2 percent. Certain other loan
interest rates were raised even more. These adjust-
ments have made the structure of interest rates more
rational and hence are beginning to make Chinese
borrowers and lenders more aware of the true cost of
Despite these major changes, the PBOC continues to
have little independent control over economic activity.
Branch banks-bowing to pressure from local au-
thorities-still tend to supply credit according to
enterprise needs, even when those needs exceed plan.
Higher interest rates, imposed on borrowing for extra-
budgetary investment, are beginning to influence de-
mand, but the central bank's ability to control excess
expenditure is still largely indirect. When a local
unit's demand for funds becomes excessive, the bank,
rather than refusing to disburse the loan, attempts to
correct the situation by notifying the government
organizations directly responsible for the units where
the deviation occurs. The reforms have, however,
given the monetary authorities more influence over
the mobilization of savings. Households have appar-
ently responded well to both higher interest rates and
the improved service offered by local banks.
The experiment with fiscal and monetary policies
deserves at least partial credit for curbing aggregate
demand pressures that had built up between 1979 and
1981. After increases in the supply of currency in
1979 and 1980 that exceeded the rise in retail sales by
a large margin, there was a return to near balance in
1981 and 1982. Currency in circulation rose only 14.5
percent in 1981 and 10.9 percent in 1982, while retail
sales showed gains of 9.8 and 9.4 percent, respective-
ly. Reduced government spending and the sale of
treasury bonds enabled Beijing to avoid monetizing
large amounts of domestic debt. The budget deficits
for the two years, though large by Chinese standards
at about 6 billion yuan in 1981 and 7 billion in 1982,
remained well below the 1979 and 1980 deficits of 21
billion yuan and 15 billion yuan, respectively. Tighter
control of wages and bonuses plus, in 1982, stable
procurement prices for agricultural goods were the
most important contributors on the monetary side to
reducing aggregate demand pressure.
capital (see table 2).
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
Table 2
China: Annual Interest Rates on Deposits and Loans
Pre-1980
Rates
Post-1980
Rates
Post-1982
Rates
Additional interest for overdue loans b
20.00
20.00
Additional interest on bank loans diverted from their authorized purpose
50.00
50.00
Agricultural bank loans
Working capital loans
Equipment loans
a Ellipses (...) indicate that the financial instrument was not used.
b Surcharges on the rate of interest.
The evidence for 1983 suggests that, although Beijing
continued to see some success in its demand-manage-
ment efforts, problems have persisted. China's new
tax and banking policies, combined with government
exhortation, finally affected enterprise investment;
extrabudgetary investment in capital construction fell
13 percent from the record 1982 level. But the budget
deficit widened in 1983 to probably about 10 billion
yuan. And because the People's Bank financed the
increase, the amount of currency in circulation
showed a sharp 21-percent rise. The rise in currency
in circulation was the first economic problem that
state councilor Song Ping highlighted in his address in
May before the National People's Congress (NPC).
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
Secret
Beijing remains concerned that, as the reforms pro-
ceed, aggregate demand will become increasingly
difficult to control. Nevertheless, Chinese leaders
reemphasized their commitment to reform at the
NPC. Hence, we expect fiscal and monetary tools to
become increasingly important supplements to Chi-
na's combined planned/market economy over the next
few years
On the fiscal side, the government is unlikely to
return to the cutbacks in its own investment program
that were imposed in 1980 and 1981. Recognition of
the importance of the key infrastructure projects to
economic development ensures increases in govern-
ment expenditure over the next few years. The share
of total investment going to the energy and transpor-
tation sectors jumped from 28 percent in 1982 to 38
percent last year, and will probably exceed 40 percent
in 1984. Large domestic budget deficits-similar to
those of 1979 and 1980-will be avoided by boosting
tax revenues through tough enforcement of existing
policies first but also through tax hikes if necessary.
The government appears prepared, however, to con-
tinue to operate somewhat in the red, at least for the
next few years. Because Beijing considers inflows
from treasury bonds and from foreign borrowing as
part of revenue rather than debt, it is also probable
that these borrowing practices will continue.
The most obvious areas for continued fiscal experi-
mentation relate to tax policy. The concept of making
individual enterprises accountable for their profits
and losses is central to the reform movement. Substi-
tuting taxes for profit remittances is the only way to
harmonize the enterprises' needs for autonomy and
the government's need for funds to finance public
projects. We expect to see major alterations in the tax
rates over the next few years. Beijing will probably
use the tax structure to penalize industries it deems
weak or undesirable and to reward those it favors. F_
In many ways, China's economic system is well suited
for monetary policy. In Western economies, a multi-
tude of constantly changing financial instruments
make control of the money supply difficult, but
Beijing has relatively few instruments for borrowing
or lending. Then too, although China's banking sys-
tem is less homogeneous than it was five years ago, it
retains many of the characteristics of a monobank.
The monetary authority should be able to exert
significant control over the entire banking system. As
a result, we believe Beijing will move ahead with
monetary reform.
The banking system will probably play a much larger
role in financing future investment. Interest rates will
probably be raised again this year, and preferential
rates may be offered for priority sectors of the
economy. We do not know what degree of autonomy
may be wielded by the new Industrial and Commer-
cial Bank, but we expect that, over the short term at
least, it will continue to function under the close
supervision of the PBOC
Although the application of monetary and fiscal
policy has given Beijing a modicum of control over the
economy that was seriously lacking in 1979-81, the
government is clearly looking for more. China's lead-
ership took significant risks in scrapping the system
built up over the past 30 years. Several members of
the party's reform wing-such as General Secretary
Hu Yaobang, Premier Zhao Ziyang, and Vice Pre-
mier Wan Li-have staked their careers on the
successful resolution of China's economic problems.
Clearly they are expecting the entire experiment to
create a more vibrant, efficient economy. Much of the
remaining waste and inefficiency, however, stem from
China's irrational price system.'?
Macroeconomic demand-management tools are par-
ticularly ill suited for dealing with relative price
problems. Restrictive fiscal and monetary policies
operate by forcing firms in all sectors to scale back
operations. The most efficient firms maintain reason-
able profits even in a tight market, while the least
profitable enterprises suffer or are driven out of
business. In China, however, profits bear no relation-
ship to efficiency or demand. Firms producing goods
'? An irrational price is one that fails to reflect supply and demand
in an economy. When Chinese prices were fixed in the early 1950s,
it is reasonable to assume that they reflected relative scarcities at
the time. In the subsequent three decades, however, Beijing made
no attempt to maintain market balance in its infrequent price
adjustments. The existence of long queues, black markets, and
complex rationing schemes is a reflection of the irrational price
I
25X1
25X1
25X1
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
whose prices have been set high may show substantial
profits despite inefficient operations even in a market
depressed by tight fiscal or monetary policies. (In
some cases these firms even produce goods that the
government has extreme difficulty marketing, either
because of low quality or lack of demand.) Conversely,
an efficient firm that uses raw materials priced
artificially high may suffer losses in a tight market.
Under these conditions, restrictive fiscal or monetary
policy could seriously damage China's best run indus-
tries. Moreover, the incentive for an inefficient firm to
streamline operations is low, and neither the reforms
nor demand-management tools offer much hope for
change.
Recognizing these weaknesses, China's leading econo-
mists have had some success pushing the government
toward price reform. Last year, prices on more than
500 minor consumer items were allowed to vary
depending on local conditions. In addition, peasants
were given increasing latitude to negotiate prices for
their surplus agricultural and sideline products.
The question of major price reform, however, remains
among the most contentious economic issues within
China's top echelons.
Deng publicly criticized u Yaobang last
summer for circulating-and apparently supporting-
a research paper calling for a radical restructuring of
the price mechanism. State President Li Xiannian
also denounced the paper, calling it antistate and
antiparty. These political and ideological concerns
have been reinforced by practical problems involving
price reform. Over the past few years, even rumors of
pending price adjustments for major commodities
have caused widespread panic buying among China's
shortage-conscious population. Several major indus-
tries and their supporting state council bureaucracies
have also resisted major price reforms because of the
impact the reforms will probably have on these firms'
irrationally high profit margins.
The long-term success of monetary and fiscal policy-
and for that matter the entire economic reform
program-hinges on price reform. If, over the next
few years, Beijing is able to couple its economic
experiment with major price reform, sizable gains are
possible. If Beijing continues to resist major price
adjustment, however, waste, inefficiency, and eco-
nomic crime will remain. Because the reform policies
remain controversial, and conservative critics tend to
attack shortcomings quickly, the longer that major
economic problems persist, the more frustrated re-
formers will become. Failure to come to grips with
price reform will, at a minimum, perpetuate the cycle
of reform and retrenchment and could precipitate-
perhaps as early as 1986-the discarding of some
economic reforms in favor of more direct control.
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
 Approved For Release 2009/03/20: CIA-RDP85TOO31 OR000200010004-0
Figure 2
China's Banking System
- Direct lines
- - - - Reporting channel but no direct authority or responsibility
State Council
China's highest economic
decision making body.
Ministry of Finance
National fiscal institution.
Compiles budget, supervises
collection of revenue, and
makes budgetary disbursements.
State Administration of
Exchange Control
Established in March 1979 to
formulate laws on foreign
exchange, supervise,fbreign
exchange receipts and disburse-
ments, and periodically
announce new exchange rates.
Central Bank Council
Formed January 1984 to give
advice on monetary policy and
banking questions. Heads of
all banks sit on the Council.
Capital Construction Bank
Given dejure independent
status under State Council in
November 1979 but Finance
Ministry continues to manage
operations. PBOC probably
continues to have considerable
say-so regarding Construction
Bank policy. Bank acts as a
conduit for capital contruction
funds under state budget. Also
handles deposits and makes
loans based on profitability.
China Investment Bank
Established in 1982 with World
Bankfunds to provide loans
for small-scale industrial
modernization projects.
Bank of China
Handles almost all foreign
transactions and accounts;
also makes foreign exchange
loans to Chinese enterprises.
China International Trust and
Investment Corporation
-- ------ ---- Established July 1979 to serve
as an intermediary in arrang-
ing joint ventures between
Chinese and foreign firms.
People's Bank of China
The central bank. Prior to 1984,
it also served as the country's
largest commercial bank.
Agricultural Bank
Reinstated in 1980 to manage
all state financial appropri-
ations for rural economy except
state-budgeted capital
construction.
Rural Credit Cooperatives
Grassroots units of the
Agriculture Bank. Formed a
relatively complete rural
financial network during entire
Communist era.
People's Insurance Company
Reinstituted in 1980 to provide
property and transportation
insurance for households and
state enterprises. Its reserves
are a source of funds for
the state.
Approved For Release 2009/03/20: CIA-RDP85TOO31 OR000200010004-0
Industrial & Commercial Bank
Formed January 1984 to take
over the commercial functions
of the People's Bank of China.
 Secret
Secret
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0
Approved For Release 2009/03/20: CIA-RDP85TOO31OR000200010004-0