CHINA’S ECONOMIC REFORM: THE TROIKA ANDREW SHENG*

My perspective of China’s economic re- form is in the context of a so-called tran- sitional socialist economy, i.e., a centrally- planned economy moving to a market- based economy. Extensive literature on this covers theories on the big-bang ap- proach as opposed to the gradualist ap- proach, etc. But the issue is much more subtle than these approaches suggest. It involves what I call the troika, which com- prises budgetary reform, enterprise re- form, and banking reform.

These three kinds of reforms are inter- related due to the peculiar structure of the centrally planned economy. In a centrally planned economy, both banks and enter- prises are owned by the state, so there is a huge moral hazard problem. As we say, ”everything is an iron rice bowl.” Enter- prises spend money, and the state pays the bills. Worse still, when the economy be- gins to reform, the problem of macro-in- stability arises. Where does this instability come from?

As the economy moves towards price reform, state enterprises begin to lose money. As the losses continue and in- crease, they are financed less by the fiscal budget and more by the banking system. Consequently, the losses of enterprises,

*Deputy Chief Executive of the Hong Kong Mon- etary Authority. This is a revised version of Dr. Sheng’s remarks in a panel session, “china: The Awakening Giant,” at Western Economic Association Inter- national’s Pacific Rim Conference in Hong Kong, Jan- uary 12, 1994. Other panelists were Steven N. S. Cheung, Head, School of Economics and Finance, Uni- versity of Hong Kong; Justin Yifu Lii, Professor and Director, China Center for Economic Research, Beijing University; and Y. C. Richard Wong, Director, Hong Kong Centre for Economic Research (HKCER), who served as moderator. HKCER and WEA International co-sponsored the session.

which comprise a quasi-fiscal deficit, begin to show up in the banks’ books, al- though the banks do not exactly show it.

This can be put in the following way. The state-owned banking system receives all deposits from the enterprise sector. In a command-type economy, the retail de- posits all are put in the national banks, which then lend everything to finance the budget deficit. The result is that as enter- prises begin to lose money under the ini- tial price reform programme. Increasing subsidies for enterprises escalate the bud- get deficit. The deficit is financed through borrowing from the banking system, thus sparking a huge inflation spiral.

Economists’ traditional advice to re- forming economies was to implement monetary policy. However, monetary pol- icy under this type of system is ineffective because as soon as the money supply is tightened, inter-enterprise credit-that is, the credit from the surplus enterprises, to the deficit enterprises-begins to increase. The accounting processes and the pay- ment system do not function well. Conse- quently, as soon as tight monetary policy is imposed, the whole economy is brought down and production begins to decline much more sharply than it would under a market-based economy.

So, clearly, when the reform process is designed, it must be a four-point process -price reform, budgetary reform, enter- prise reform, and banking reform-and these must be very carefully sequenced. Some economists in Eastern Europe have made severe mistakes in understanding the problems of reform, particularly on the banking side. They also have underesti- mated the dangers of sharp declines in production arising from premature mone-

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16 CONTEMPORARY ECONOMIC POLICY

tary policy actions. In addition, they have misunderstood the transmission mecha- nism of monetary policy in relation to the banking system and the inter-enterprise credit problem.

As for China, up to this point in the reform period, all the above problems have existed in some form. A few statistics illustrate. In 1978, 60 percent of China’s total revenue was based on taxation of en- terprises. By 1992, this had declined to about 18.8 percent. At the same time, the central budget reimbursement of loss- making enterprises has been very large, roughly about 2 percent of GDP. To the extent that the banking system was able to generate or mobilize a large amount of re- sources because of the high saving rate the process for the most part has not been in- flationary.

However, in the 1988-1989 period as well as more recently, inflation began to increase. This reflects in part the ineffi- ciencies in the real sector and the difficul- ties of implementing monetary policy. When monetary policy is tightened in a reforming economy, inter - e n t e r p r i se credit-which in China is called ”triangu- lar debt”-increases because enterprises refuse to pay each other. Therefore, pro- duction slows down dramatically, some- times resulting in the need to pump in more credit. When this happens it sparks the next round of monetary growth, which then leads to potential inflation problems.

What is the role of the banking system in enterprise reform? This is the central issue being debated in countries with re- forming economies. One aspect is that the banking system should not finance the budget in order to bring about macroeco- nomic stability. Also banks should have the role of imposing financial discipline on the enterprises. Clearly, in almost all tran- sitional economies, including China’s, the ability of banks to perform this function has been extremely limited. Banks have not had the institutional capacity nor the

ownership structure to impose corporate governance.

There is a huge debate going on about the role of the banking system. Colin Mayer has talked about whether a country should use the German universal banking system or the Anglo-Saxon banking sys- tem. Under the German universal banking system, the banks exercise financial disci- pline on enterprises by owning them, whereas under the Anglo-Saxon system banks do not interfere in corporate gover- nance per se.

In China, the crux of the problem has been tackled. First, the banks will not be allowed to lend to finance the budget. Budget deficits must be financed through bond issues and tax reform. Extensive tax reform has been achieved by moving to- wards the value-added tax. Second, enter- prises have not moved towards privatisa- tion but towards incorporation. That means forcing enterprises to be more profit-oriented to meet the market de- mand and to respond to market signals.

Comprehensive banking laws and the central banking law have been introduced (i) to make the Peoples’ Bank of China a classical central bank in charge of mone- tary policy and (ii) to establish policy- based banks. The latter is to remove pol- icy-based loans from the specialised banks and install them in policy-based banks. It also is intended to force the banks them- selves to become more market-oriented and profit-oriented. The institutional re- form, which is being supported by advice from the World Bank, is proceeding grad- ually and will take considerable time. Therefore, the banks‘ ability to impose fi- nancial discipline on the enterprises will remain weak for some time to come.

The other major problem in the trans- formation process during the reform is risk management. This problem basically is as follows: enterprises in the command economy have infinite gearing; the capital base is almost zero and the debt, which is

SHENG CHINA’S ECONOMIC REFORM-THE TROIKA 17

borrowed from both the state and state- owned banks, is infinite. So they are ex- tremely vulnerable to financial shocks. That means if any shock occurs, these en- terprises literally collapse. In addition, the ability of enterprises at the early stages of the game to respond to interest rate changes is very small. The production of enterprises will not decrease with rises in the interest rate.

So, the only way actually to stabilise the whole transformation process is to stabi- lize the financial structures in all three areas. First, on the budget side, one must stabilize the revenue base and control ex- penditures. Second, on the banking side, one must control or improve credit disci- pline as well as increase banks’ capital ad- equacy. Previously, because banks were all state-owned, they did not need high cap- ital adequacy. But a more volatile price transformation situation requires increas- ing bank supervision and increasing banks’ ability to impose credit discipline on enterprises and therefore on their own capital adequacy. Third, one must im- prove the capital base of enterprises. A fundamental difference between the Chi- nese reforms and those in Eastern Europe is the more rapid development of stock markets in China and also the influence of the Hong Kong stock market through the introduction of the H shares. Nine Chinese state enterprises now have been allowed to float in Hong Kong, out of which at

least six already have been listed. These six altogether have raised about a billion dollars of capital in Hong Kong. Their market capitalisation at the end of 1993 was roughly over $2.5 billion. What is ef- fectively happening is that as these enter- prises begin to incorporate and raise cap- ital in the capital market, they reduce their gearing. Moreover, if they quote their shares in, for example, Hong Kong, or in- ternationally, they are subject to better cor- porate governance because all the incen- tive structure is properly in place. Their shares will be subject to flotation rules in Hong Kong, and these enterprises will be subject to international auditing, account- ing, and legal standards. The incentive structure more effectively will allow these enterprises to move closer and closer to the market structure. If these enterprises do not deliver, market signals will be sent and their share prices will drop. In gen- eral, they will be much more subject to the market process.

In that regard, Hong Kong provides an- other degree of freedom in the reform pro- cess in China relative to that in Eastern Europe. In Eastern Europe, the stock mar- kets have not been very liquid and the legal framework has not moved signifi- cantly. Therefore, these markets are sub- ject to greater volatility, the same volatility as in the Shanghai and Shenzhen stock markets.